Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent ordinary equity.The firm expects to earn R600 in after-tax income during the coming year, and it will retain 40 percent of those earnings.The current market price of the firm's shares is P0 = R28; its last dividend was D0 = R2.20, and its expected dividend growth rate is 6 percent.Allison can issue new ordinary shares at a 15 percent flotation cost.What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring R600 in total new capital?

Question

Quizplus · Accepted Answer

The marginal cost of equity capital can be calculated using the Gordon Growth Model (Dividend Discount Model) adjusted for flotation costs:  Cost of Equity = (D1 / (P0 * (1 - Flotation Cost))) + Growth Rate  Where D1 = D0 * (1 + Growth Rate) = 2.20 * 1.06 = 2.332  Cost of Equity = (2.332 / (28 * (1 - 0.15))) + 0.06 = 15.8%

Allison Engines Corporation Has Established a Target Capital Structure of 40