Bouchard Company's stock sells for $20 per share, its last dividend was $1.00. Its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the amount of common equity in the capital structure is 60 percent. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?
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A. B. C. D. E.Explanation
BP(RE) = RE/Equity fraction = $1,000,000/0.6 = $1,666,667.
Since the capital budget will be $2 million, and since all equity in the WACC (Weighted Average Cost of Capital) beyond $1,666,667 will be external equity, the
WACC of the last dollar raised will include equity at a cost of k(e) (component cost of external equity obtained by issuing new common stock as opposed to retaining earnings): k(e) = $1(1.06)/$20(1 - 0.2) + 0.06 = 0.0663 + 0.06 = 0.1263 = 12.63%.