Question

Banyan Co.’s common stock currently sells for $53.25 per share. The growth rate is a constant 8%, and the company has an expected dividend yield of 2%. The expected long-run dividend payout ratio is 20%, and the expected return on equity (ROE) is 10.0%. New stock can be sold to the public at the current price, but a flotation cost of 15% would be incurred. What would be the cost of new equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Answer:Cost of New Equity (
`K_(e)`) = 20.75%

Step-by-step explanation:

Banyan Company’s common stock currently sells(
`P_(0)`) = $53.25

Growth rate is constant (g) = 8%

Expected dividend yield = 2%

Expected long-run dividend payout ratio = 20%

Expected return on equity (ROE) = 10%

Flotation cost(F) = 15%

We know that ;

Growth rate = (1-Dividend payout ratio) (ROE)

8% = (1-0.20)
`*`(0.10)

Cost of new equity (ke) =
`[(D_(1) )/(P_(0)* (1 - F) )] + g`

where;

F = Flotation cost

(
`D_(1)`) = Expected Dividend

(
`P_(0)`) = Current Stock price

g = Dividend growth rate

Calculating expected dividend:

Dividend yield =
`[(D_(1) )/(P_(0))`

15% =
`[(D_(1) )/(53.25)`

`D_(1)` = 15%
`*` 53.25

Expected Dividend (
`D_(1)`) = $7.9875

Cost of New Equity (
`K_(e)`) =
`[(7.9875)/(53.25* (1 - 0.15) )] + 0.08`

=
`[(7.9875)/(62.64)] + 0.08`

= 0.207 (or) 20.75%

Cost of New Equity (
`K_(e)`) = 20.75%

Actually Investors required rate of return i.e. ROE = 10% on the stock, but because of flotation costs the company must earn more than 10%.