Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.The firm expects to earn $600 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 stock is P0 = $28; its last dividend was D0 = $2.20,and its expected dividend growth rate is 6 percent.Allison can issue new common stock 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 $600 in total new capital?

Question

Quizplus · Accepted Answer

The correct answer is A. The marginal cost of equity capital is the cost of raising new equity capital. It is calculated as the sum of the flotation cost and the cost of new equity. The cost of new equity is calculated as the dividend yield plus the expected growth rate. In this case, the flotation cost is 15%, the dividend yield is 2.20/28 = 7.86%, and the expected growth rate is 6%. Therefore, the cost of new equity is 7.86% + 6% = 13.86%. The marginal cost of equity capital is therefore 15% + 13.86% = 15.8%.

Allison Engines Corporation Has Established a Target Capital Structure of 40