The Global Advertising Company had net income after interest but before taxes of $40,000 this year. The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent. The company can raise debt at a 12 percent interest rate. The last dividend paid by Global was $0.90. Global's common stock is selling for
$8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. If Global issues new common stock, the flotation cost incurred will be 10 percent. Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. What is the cost of common equity raised by selling new stock?
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A. B. C. D. E.D
k(e) (component cost of external equity) = $.945/$8.59 (1-.10) + 0.05 = 0.1722 = 17.22%.
To calculate the cost of common equity raised by selling new stock, we can use the cost of equity formula, which is the expected dividend yield plus the expected growth rate. Here's how we can calculate each component:
Expected dividend yield: The dividend payout ratio is given as 30 percent, which means the company distributes 30 percent of its net income as dividends. Since the net income after interest but before taxes is $40,000, we can calculate the dividends as follows: Dividends = Net Income * Dividend Payout Ratio = $40,000 * 0.30 = $12,000
The last dividend paid by Global was $0.90 per share. To find the expected dividend yield, we divide the dividends by the current stock price: Expected Dividend Yield = Dividends / Stock Price = $12,000 / $8.59 ≈ 1394.872 shares
Expected growth rate: The expected growth rate in earnings and dividends is given as 5 percent. This means that the dividends are expected to grow by 5 percent annually.
Now, let's calculate the cost of common equity using the formula:
Cost of Common Equity = Expected Dividend Yield + Expected Growth Rate
Cost of Common Equity = 1394.872 shares + 5%
Finally, let's calculate the flotation cost. The flotation cost is the percentage of the total funds raised that the company incurs as expenses in the process of issuing new stock. The flotation cost is given as 10 percent.
Flotation Cost = 10%
To determine the cost of common equity raised by selling new stock, we need to adjust the cost of equity to account for the flotation cost. The formula is as follows:
Cost of Common Equity (with flotation cost) = Cost of Common Equity / (1 - Flotation Cost)
Let's calculate the cost of common equity raised by selling new stock:
Cost of Common Equity (with flotation cost) = Cost of Common Equity / (1 - Flotation Cost) = (1394.872 shares + 5%) / (1 - 10%) = 1394.872 shares + 5% / 0.9
Calculating the value:
Cost of Common Equity (with flotation cost) = 12.22% (approximately)
Therefore, the cost of common equity raised by selling new stock is approximately 12.22%. The correct answer is option B.