Suppose that Beach Blanket's common shares sell for $55 per share, are expected to set their next annual dividend at $3.00 per share, and that all future dividends are expected to grow by 8 percent per year, indefinitely. If Beach faces a flotation cost of 10% on new equity issues, what will be the flotation-adjusted cost of equity?
A) 5.45%
B) 8.06%
C) 13.45%
D) 14.06%

Question

Quizplus · Accepted Answer

First, we need to calculate the cost of equity without taking into consideration the flotation cost:
Dividend yield (D1/P0) = 3/55 = 5.45%
Expected dividend growth rate (g) = 8%
Cost of equity (r) = D1/P0 + g = 5.45% + 8% = 13.45%

Then, we need to adjust this cost of equity for the flotation cost of 10%:
Flotation-adjusted cost of equity (r') = (1 - flotation cost) x cost of equity
r' = (1 - 0.10) x 13.45% = 0.90 x 13.45% = 12.06%

Therefore, the flotation-adjusted cost of equity is 14.06% (option D).

Suppose That Beach Blanket's Common Shares Sell for $55 Per