Allison Engines Corporation | Marginal Cost of Equity Capital Calculation

Marginal Cost of Equity Capital

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Question

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 $28; its last dividend was $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?

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A. B. C. D. E.

D

Calculate the retained earnings break point:

Given:

Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.

Break point(RE) = $600(1 - 0.6)/0.6 = $400.

Allison will need new equity capital; capital budget exceeds Break point(RE).

Use the dividend growth model to calculate k(s):

k(s) = D1/Po + g = 2.2(1.06)/28(1-.15) + .06 = 0.0979 + 0.06 = 0.1579 = 15.8%. k(s) = component cost of retained earnings or internal equity.

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