Suppose that Wave Runners' common shares sell for $35 per share, are expected to set their next annual dividend at $2.00 per share, and that all future dividends are expected to grow by 10 percent per year, indefinitely. If Wave faces a flotation cost of 15 percent on new equity issues, what will be the flotation-adjusted cost of equity?
A) 6.73 percent
B) 10.07 percent
C) 15.71 percent
D) 16.72 percent

Question

Quizplus · Accepted Answer

The flotation-adjusted cost of equity can be calculated using the dividend discount model (DDM) adjusted for flotation costs. The formula for the cost of equity without flotation costs is given by $r = \frac{D_1}{P_0} + g$, where $r$ is the cost of equity, $D_1$ is the dividend next year, $P_0$ is the current price, and $g$ is the growth rate. Here, $D_1 = $2.00$, $P_0 = $35$, and $g = 10\%$ or 0.10. Plugging these values in gives us $r = \frac{2.00}{35} + 0.10 = 0.0571 + 0.10 = 0.1571$ or 15.71% as the basic cost of equity.However, we need to adjust this for flotation costs. The price that the company actually receives for new equity is $P_0$ adjusted for flotation costs, which is $P_0 \times (1 - \text{flotation cost rate})$. Here, the flotation cost rate is 15% or 0.15, so the adjusted price is $35 \times (1 - 0.15) = 35 \times 0.85 = 29.75$.Using the adjusted price in the DDM formula, we get the flotation-adjusted cost of equity as $r = \frac{2.00}{29.75} + 0.10 = 0.0672 + 0.10 = 0.1672$ or 16.72%.

Suppose That Wave Runners' Common Shares Sell for $35 Per