Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. What is the component cost of the equity raised by selling new common stock?
Click on the arrows to vote for the correct answer
A. B. C. D. E.E
k(e) (component cost of external equity) = ($2.10/$21.88(1-.20)) + 0.05 = 17%.
To calculate the component cost of equity raised by selling new common stock, we need to use the dividend growth model, also known as the Gordon growth model. The formula for the Gordon growth model is:
Ke = (D1 / P0) + g
Where: Ke = Cost of equity D1 = Expected dividend per share next year P0 = Current equilibrium stock price g = Dividend growth rate
Let's calculate the required values step by step:
Calculate the expected dividend per share next year (D1): Given: Last dividend = $2.00 Dividend growth rate = 5%
D1 = Last dividend × (1 + Dividend growth rate) = $2.00 × (1 + 0.05) = $2.00 × 1.05 = $2.10
Calculate the cost of equity (Ke): Given: Current equilibrium stock price (P0) = $21.88
Ke = (D1 / P0) + g = ($2.10 / $21.88) + 0.05 ≈ 0.096 + 0.05 ≈ 0.146 ≈ 14.6%
Therefore, the component cost of the equity raised by selling new common stock is approximately 14.6%.
The correct answer is C. 14.6%.