6. Cost of new common stock Aa Aa True or False: The following statement accurat

Question

6. Cost of new common stock Aa Aa 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 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. Sunny Day Manufacturing Company is considering investing in a one-year project that requires an initial investment of $500,000. 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 $550,000. The rate of return that Sunny Day expects to earn on its project (net of its flotation costs) is (rounded to two decimal places).

Explanation / Answer

1) False

2)

Rate of return = (550000 / 500000*(1-2%)) - 1 = 7.8%

return on common stock = (2.03 / 33.35*(1-6.5%) ) + 5.2% = 10.89%

breakpoint = 420000 / 55% = 763636 (Option 4)

3)

a)

Difference in WACC = 36% * (14.2% - 12.4%) = 0.65% (Option 4)

b)

Wd = 100000/270000 = 37.04%

Wp = 30000/270000 = 11.11%

We = 140000/270000 = 51.85%

WACC = 37.04%*9.6%*(1-40%) + 51.85%*13.5% + 11.11%*10.7% = 10.32%

4)

Cost of Debt (Rd) = RATE(5,10%*1000,-1050.76,1000) = 8.7%

Cost of Equity (Re) = (D1/(P0 * (1 - Flotation) ) + growth = (2.78 / (33.35*(1-3%))) + 9.2% = 17.79%

Cost of preferred shares (Rp) = 8/92.25 = 8.67%

WACC = 58%*8.7%*(1-40%) + 36%*17.79% + 6%*8.67% = 9.95%

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