Cost of New Equity
Cost of new equity is the cost of a newly issued common stock that takes into account the flotation cost of the new issue. Flotation cost is the cost paid by the company to investment bankers for their services in the public offering. Flotation cost increases the cost of equity such that cost of new equity is higher than cost of (existing) equity.
Cost of new equity is calculated using a modification of the dividend discount model. Flotation cost is normally a percentage of the issue price. It is incorporated into the model by reducing the price of the share by the percentage of the flotation cost.
Many financial analysts argue that since flotation cost is a one-time cost, its inclusion in the cost of equity overstates the cost of capital forever and results in bad corporate finance decisions. They recommend adjusting cash flows for the flotation cost.
The following formula is used to calculate cost of new equity:
|Cost of New Equity =||D1||+ Growth Rate|
|Price × (1 − F)|
D1 is dividend in next period
Price is the issue price of a share of stock
F is the ratio of flotation cost to the issue price
Growth Rate is the dividend growth rate
XY Systems raised $300 million in fresh issue of commons stocks. The issue price was $25 per share, 4% of which was paid to the investment bankers. The company is expected to pay $2 in dividend per share next year. Dividends are expected to increase by 5% per year. Calculate the cost of new equity and compare it to the cost of (existing) equity.
|Cost of New Equity =||$2||+ 5% = 13.3%|
|$25 × (1 − 4%)|
|Cost of (Existing) Equity =||$2||+ 5% = 13%|
The flotation costs have increased cost of equity by 0.3%.
Written by Obaidullah Jan