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 costs are the costs incurred by the company in issuing the new stock. Flotation costs increase 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 costs.

Formula

The following formula is used to calculate cost of new equity:

Cost of New Equity =D1 + g
P0 × (1 − F)

Where,
D1 is dividend in next period
P0 is the issue price of a share of stock
F is the ratio of flotation cost to the issue price
g is the dividend growth rate.

The growth rate referred above is the sustainable growth rate which equals the product of retention ratio and return on equity (ROE):

g = Retention Ratio × ROE

Example

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.

Solution

The cost of the fresh issue of common stock can be calculated as follows:

Cost of New Equity =$2 + 5% = 13.3%
$25 × (1 − 4%)

Calcualtion of cost of (existing) equity does not need to account for flotation cost:

Cost of (Existing) Equity =$2 + 5% = 13%
$25

The flotation costs have increased cost of equity by 0.3%.

by Obaidullah Jan, ACA, CFA and last modified on

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