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.

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RenatoMattice RenatoMattice · Answer 1 · 2019-07-24T11:16:11+02:00

Answer:Cost of New Equity ([tex]K_{e}[/tex]) = 20.75%

Explanation:

Banyan Company’s common stock currently sells([tex]P_{0}[/tex]) = $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)[tex]\times[/tex](0.10)

Cost of new equity (ke) = [tex][\frac{D_{1} }{P_{0}\times (1 - F) }] + g[/tex]

where;

F = Flotation cost

([tex]D_{1}[/tex]) = Expected Dividend

([tex]P_{0}[/tex]) = Current Stock price

g = Dividend growth rate

Calculating expected dividend:

Dividend yield = [tex][\frac{D_{1} }{P_{0}}[/tex]

15% = [tex][\frac{D_{1} }{53.25}[/tex]

[tex]D_{1}[/tex] = 15%[tex]\times[/tex] 53.25

Expected Dividend ([tex]D_{1}[/tex]) = $7.9875

Cost of New Equity ([tex]K_{e}[/tex]) = [tex][\frac{7.9875}{53.25\times (1 - 0.15) }] + 0.08[/tex]

= [tex][\frac{7.9875}{62.64}] + 0.08[/tex]

= 0.207 (or) 20.75%

Cost of New Equity ([tex]K_{e}[/tex]) = 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%.