Mike is analyzing the performance of the shares of ABC Corporation. As per the latest information, ABC Corporation is planning to issue additional common equity. Key information in Mike"s evaluation of the stock, is as follows : 1) Dividend paid per share = $3.00, 2) Expected Dividend growth rate = 2%, 3) Floatation cost = $3.50 per share, 4) Tax rate = 35% 5) Beta = 0.7,6) Current share price = $35.00. Based on the above information, which of the following rates is “closest” to the cost of newly issued equity shares ? A) 11.7% B) 11.5% C) 10.7% D) 10.5% Enjoy

A?

Nice map! Well done! Rock and Roll!!!

Nice distractors:) tax rate and beta:)

Can you elaborate on your solution? What formula have you applied and why? and how did you read the question I find this question EXTREMELY HARD.

Cost of newly issued equity = [Dividend paid*(1+growth rate)/(Current stock Price - flotation cost)]+ growth rate=3*1.02/(35-3.5)+0.02=11.71%

map1 Wrote: ------------------------------------------------------- > Cost of newly issued equity = + growth > rate=3*1.02/(35-3.5)+0.02=11.71% Exactly

The equation that map provided may also be written as >>> 35 - 3.5 = 31.5 = 3*1.02/(r-0.02) Some of you may find it convenient to read it this way!

map1 Wrote: ------------------------------------------------------- > Cost of newly issued equity = + growth > rate=3*1.02/(35-3.5)+0.02=11.71% but this is incorrect way of estimating cost of equity ?? Study session 11 schweser pg 43

I don’t have Schweser.

I think it is correct thunder. Can you write down what it is written in the schweser book because I use stalla! Thanks

hmmm… CFAI text Corporate Finance Pg- 69…

Schweser clearly states that using the above approach is a common mistake in calculating cost of equity and there is a highlighted warning against using the above formula

So, where is the problem? D1=3*1.02 P0=35 F=3.5 g=0.02

What’s the formula in Schweser?

This is the formual when flotation costs are incorporated into WACC: Rcommon equity= [DIV1 / Pcs (1-f)] + g when f is taken as a precentage of the issue price othewise: Rcommon equity= [DIV1 / Pcs - F] + g = [DIVo(1+g) / Pcs -F] + g where F is the flotation cost per share (as in the exercise). This is also what is written in Stalla.

And schweser says, this is wrong because this will result in higher cost of equity, and future cash flows are discounted at this higher WACC (or cost of equity). The problem with this approach is that flotation costs are not on going expense for the firm. Flotation costs are one time cash outflow that occurs at the initiation of project.

I know…check carefully, in stalla says “the problem with this approach is that the flotation costs are incurred immediately, but the cost itself is adjusting the present value of future cash flows” Doesnt say it is wrong…its just says that it may not be very accurate. It is like saying… “using effective and modified duration”, the first it is more accurate than the latter, but that does not mean that the second its wrong. I hope this helps.

There are 2 different views on this: one that is fine to consider the flotation cost, the other that is not fine at all and flotation costs should be deducted from the NPV of a project that is to be financed with the newly issued equity and debt, where the cost of equity is calculated without flotation costs, with the good old DDM. I can see both ends of this, and given the above problem I do believe including flotation costs is what the question is asking for. What’s Schweser’s point on how to deal with a problem like the above? Calculate cost of equity without flotation? Like in DDM?

It is A – all the question is asking you to do is find the cost of equity using the div discount model – but it throws the flotation cost in there to throw you off. I did: 3.06/31.50 + 2% = 11.7% Use 3.06 b/c you need NEXT years dividend, not the current year’s