6. Cost of new common stock True or False: The following statement accurately de
ID: 2563160 • Letter: 6
Question
6. Cost of new common stock True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. The cost of issuing new common stock is calculated the same way as the cost of raising equity capital from retained earnings. O True: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of retained earnings is based on the firm's existing common equity, while the cost of new common stock is based on the value of the firm's share price net of its flotation cost. O False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings White Lion Homebuilders is considering investing in a one-year project that requires an initial investment of $475,000. To do so, it will have issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $595,000. The rate of return that White Lion expects to earn on its project (net of its flotation costs) is (rounded to two decimal places)Explanation / Answer
1. Answer is True. Cost of raising new common stock is same as the cost of raising equity from retained earnings except from that while calculating the cost of new common stock, market price of shares net of flotation cost is considered.
Formula for cost of new Common Stock(Kc) = [D1 / P0 (1-Flotation Cost) x 100 ] + g.
Formula for cost of raising equity from retained earnings(Ks) = [D1 / P0 x 100] + g
Where, D1 = Divdends expected to be paid next year.
P0 = Current Market price per shares
g = growth rate of company.
2. Flotation cost is the cost incurred by the company for raising the equity share capital in the market. And therefore, such cost is added to the intital investment of the project. In the given, question Total Inital Invenstment will be as follows:
Total Intial Invenstment = Initial Investment required + Flotation Costs associated in raising capital.
= $475,000 + 2% of $475,000 = $484,500
Cash inflows from project = $595,000
Return from Invenstment = Cash inflows from project - Total initial Investment.
= $595,000 - $484,500 = $110,500
Rate of Return = Return from Investment / Initial Investment (Including Flotation Cost) x 100
= $110,500 / 484,500 x 100 = 22.81% Approx.
3. Cost of issuing new Common Stock(Kc) = [D1 / P0 (1-Flotation Cost) ] + g.
Where, D1 = Divdends expected to be paid next year.
P0 = Current Market price per shares
g = growth rate of company.
D1 = $2.03.
P0 = $22.35
g = 9.40%
Flotation Cost = 3.750%
Net of Flotation cost price of shares = $22.35 (1 - 3.750%) = $22.35 (0.9625) = $21.512.
Putting the figures in above mentioned formula we get:
Kc = [$2.03 / $21.512 x 100] + 9.40% = 9.44% + 9.40% = 18.84%
4. In the last part more details required regarding the cost of Debt & cost of preferred stock. In absence of the same the solution cannot be given for this part of question.
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