A firm has common stock with a market price of $100 per share and an expected dividend of $5.61 per share at the end of the coming year. A new issue of stock is expected to be sold for $98, with $2 per share representing the underpricing necessary in the competitive capital market. Flotationcosts are expected to total $1 per share. The dividends paid on the outstanding stock over the past five years are as follows:$$\begin{array} { c c }
\text { Year } & \text { Dividend } \
\hline 1 & \$ 4.00 \
2 & 4.28 \
3 & 4.58 \
4 & 4.90 \
5 & 5.24
\end{array}$$ The cost of this new issue of common stock is
A) 7.7 percent.
B) 10.8 percent.
C) 12.8 percent.
D) 5.8 percent.

Question

A firm has common stock with a market price of $100 per share and an expected dividend of $5.61 per share at the end of the coming year. A new issue of stock is expected to be sold for $98, with $2 per share representing the underpricing necessary in the competitive capital market. Flotationcosts are expected to total $1 per share. The dividends paid on the outstanding stock over the past five years are as follows:$$\begin{array} { c c } 
\text { Year } & \text { Dividend } \
\hline 1 & \$ 4.00 \
2 & 4.28 \
3 & 4.58 \
4 & 4.90 \
5 & 5.24
\end{array}$$ The cost of this new issue of common stock is
A) 7.7 percent.
B) 10.8 percent.
C) 12.8 percent.
D) 5.8 percent.

Quizplus · Accepted Answer

The cost of new equity can be calculated using the dividend growth model: Cost of new equity = (D1 / P0) + g, where D1 is the expected dividend, P0 is the net proceeds from the sale of the stock, and g is the growth rate. The growth rate (g) can be calculated using the historical dividends: g = (5.24/4.00)^(1/4) - 1 = 0.07 or 7%. The net proceeds (P0) = $98 - $1 = $97. Therefore, the cost of new equity = ($5.61 / $97) + 0.07 = 0.128 or 12.8%.

A Firm Has Common Stock with a Market Price of $100