Taking flotation costs into account will reduce the cost of new common stock. Tr

Question

Taking flotation costs into account will reduce the cost of new common stock. True: Taking flotation costs into account will reduce the cost of new common stock, because you will multiply the cost of new common stock by 1 minus the flotation cost-similar to how the after-tax cost of debt is calculated O False: Flotation costs are additional costs associated with raising new common stock Alpha Moose Transporters 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 Alpha Moose expects to earn on its project (net of its flotation costs) is (rounded to two decimal places) Sunny Day Manufacturing Company has a current stock price of $22.35 per share, and is expected to pay a per-share dividend of $2.03 at the end of next year. The company's earnings' and dividends' growth rate are expected to grovw at the constant rate of 5.20% into the foreseeable future. If Sunny Day expects to incur flotation costs of 5.00% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be Alpha Moose Transporters Co.'s addition to earnings for this year is expected to be $420,000. Its target capital structure consists of 50% debt, 5% preferred, and 45% equity. Determine Alpha Moose Transporters's retained earnings breakpoint: O $933,333 O $1,166,666 $1,026,666 $1,120,000

Explanation / Answer

a.Taking Floatation cost in calculation of cost of Equity will always increase the Cost of Equity. Cost of equity is given by: Ke= [D1/(P0-F)]+g , In denominator Share price(P0) will reduce by Floatation cost(F) and the cost of Equity will increase. Threfore the statatement is False.

b.Issue Proceeds= $ 475000- 2% of 475000(floatation cost)= $ 465500

Expectred cashflow at the end of year = $595000

E(R)= (595000-465500)/465500*100= 27.82%

c.Cost of equity is given by: Ke= [D1/(P0-F)]+g

D1= Expected dividend , P0= current Price, F= floatation cost, g= Growth rate

Here F= 5% of 22.35= $1.1175

Ke= [2.03/(22.35-1.1175)]+0.052= 0.1476 or 14.76%

d.Breakeven retained earnings are given by:

BP(re)=Earnings/ Share of Equity

= 420000/0.45= $933,333

$933333 can be financed with RE, debt and Preferred shares.

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