Surfin' Bubba Surfboard Shop is currently selling for $34.25 a share with a current dividend of $1.00. It is estimated that Surfin' Bubba will have a growth rate in earnings of 10% into the foreseeable future. If Surfin' Bubba plans to raise new capital for expansion, what is the cost of new equity if flotation costs are 8% of the price?

Question

Quizplus · Accepted Answer

The cost of new equity can be calculated using the formula for the cost of equity with growth (Gordon Growth Model) and adjusting for flotation costs. The formula for the cost of equity (ke) is: ke = (D1 / P0) + g, where D1 is the dividend next year, P0 is the current price, and g is the growth rate. Since the dividend is expected to grow at a 10% rate, D1 = $1.00 * (1 + 0.10) = $1.10. However, because of the 8% flotation costs, the actual price received by the company after issuing new shares would be P0 * (1 - 0.08) = $34.25 * (1 - 0.08) = $31.51. Thus, the cost of new equity is ke = ($1.10 / $31.51) + 0.10 = 0.0349 + 0.10 = 13.49%.

Surfin' Bubba Surfboard Shop Is Currently Selling for $34