Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $31.00 per share. The firm's dividend for next year is expected to be $5.30 with an annual growth rate of 7.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 14.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external equity?

Cost of external equity = 26.9%

Explanation

According to the dividend valuation, the value of a stock is the present value of expected future dividends discounted at the required rate of return.

The model can me modified to determined the cost of equity having flotation cost as follows:

Ke = D (1+r) / P (1-f) + g

Ke = Cost of equity

D - current dividend,

D (1+g) - dividend next year

p - price of stock - 31,00$

f - flotation cost - 14%

g - growth rate - 7%

Ke = 5.30/31 * (1-0.14) + 0.07

= 0.2687997 * 100

= 26.9%