Becker Glass Corporation
Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent.
-Refer to J.Ross and Sons.What is the firm's cost of newly issued common stock?

Question

Quizplus · Accepted Answer

The cost of newly issued common stock can be calculated using the dividend discount model (DDM) adjusted for flotation costs. The formula for the cost of new equity ($r_e$) is $r_e = \frac{D_1}{P_0(1 - f)} + g$, where $D_1$ is the dividend next year, $P_0$ is the current price of the stock, $f$ is the flotation cost as a decimal, and $g$ is the growth rate. Given that the firm pays out 50% of its earnings as dividends, the dividend next year ($D_1$) can be calculated as 50% of the earnings after interest and taxes, grown at the growth rate of 12.5%. However, since the earnings and dividends grow at a constant rate, the payout ratio and growth rate allow us to directly use the growth rate in the formula. The current price is $40, and the flotation cost is 10%, making $f = 0.10$. Thus, $r_e = \frac{D_1}{40(1 - 0.10)} + 0.125$. To find $D_1$, we note it's not directly needed because the growth rate is given and the payout ratio remains constant. The cost of equity is thus calculated by adjusting the current price for flotation costs and adding the growth rate. With the given information, the calculation simplifies to adjusting the price for flotation costs and adding the growth rate, leading to a higher cost of equity than the growth rate alone due to the flotation costs. The correct calculation involves recognizing that the flotation cost increases the required return from investors to compensate for the lower proceeds received by the company due to the flotation costs. Given the options, the correct answer involves recognizing the impact of flotation costs on the cost of new equity, leading to an answer that reflects a higher cost than the growth rate or the cost of retained earnings.

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