Given the following, compute the cost of externally generated equity (new equity

Question

Given the following, compute the cost of externally generated equity (new equity) using the DCF approach: The par value of the firms outstanding 20 year 8% annual coupon debt is 1,000 and the debt currently has a market value of 800. The firm's tax rate is 30%. The current dividend (just paid) is 2.00. The dividend growth rate is 3%. The current stock price is 20.00. New equity flotation costs are 10%. The risk free rate is 4%. The market risk premium (Market return - Risk free rate) is 6%. The security beta is 2.

Explanation / Answer

Flotation cost = 10%

So issue price = current price * (1+flotation cost) = 20 * (1+10%) = 22

Next year dividend = current dividend * (1+growth rate) = 2 * (1+3%) = 2.06

Cost of externally generated equity = next year dividend / issue price + dividend growth rate = 2.06 / 22 + 3% = 12.36%

Answer: Cost of externally generated equity = 12.36%

Hope this helped ! Let me know in case of any queries.

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