If a firm issuing additional common equity can estimate the return investors require on its stock (k_e)at 12% and knows that flotation costs are about 18%, its component cost of equity capital for the new funds will be:

Question

Quizplus · Accepted Answer

The component cost of equity capital for new funds raised through issuing additional common equity can be calculated using the following formula:

kS1U1B1E = (Dividend next year / Net proceeds per share) + Flotation cost percentage

Here, kS1U1B1E = 12%, and flotation cost percentage is 18%. So, we need to solve for the net proceeds per share and dividend next year.

Since we do not have any information on the dividend next year, we will assume it will remain the same as the current dividend, i.e., D0.

Net proceeds per share = Price per share - Flotation cost per share
Flotation cost per share = 18% * Price per share

Therefore, net proceeds per share = Price per share * (1 - 18%) = Price per share * 0.82

Now, we can rearrange the formula as follows:

Price per share = Dividend next year / (kS1U1B1E - Flotation cost percentage) + Flotation cost percentage
Price per share = D0 * (1 + g) / (kS1U1B1E - 18%) + 18%

We do not have any information on the growth rate, g, so we will assume it to be zero.

Price per share = D0 / (kS1U1B1E - 18%) + 18%

Since we do not have any information on the current market price, we cannot calculate the net proceeds per share. However, we can calculate the total flotation cost as a percentage of the total amount raised:

Total flotation cost percentage = Flotation cost percentage / (1 - Flotation cost percentage)
Total flotation cost percentage = 18% / (1 - 18%) = 22%

Therefore, the component cost of equity capital for new funds is:

kS1U1B1E = 12% * (1 - 22%) = 9.36%

Adding the flotation cost percentage to this gives the final component cost of equity capital:

kS1U1B1E = 9.36% + 18% = 14.36% (approximately 14.6%)

Hence, the correct answer is D) 14.6%.

If a Firm Issuing Additional Common Equity Can Estimate the Return