Individual Cost Of Capital-Common Stocks (Part 2of 2)

May 17th, 2008 Comments off
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There are two means of getting finance from common stocks namely:

  • Retained earnings or internal common equity(Ke)
  • External common equity (Kne)- the issuance of NEW common stocks.

Let’s see how we can compute the aforesaid’s cost of capital

Method To Compute Of Cost Of EXTERNAL Common Equity

  • The cost of issuing new common stock(Kne) is similar to the cost of internal equity except that a company has to incur flotation costs.

Dividend Growth Model

  • The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return

Formula is Ke(Required rate of return)= D1/NPo + g

Where NPo is the net proceeds per share received by the company

And D1=Do(1+g)

Illustration Using the DIVIDEND GROWTH MODEL BASIS ON EXTERNAL COMMON EQUITY ( WITH FLOTATION COSTS)

Company XYZ Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3. The flotation costs equal 15% of market price. Compute the investors’ required rate of return using the Dividend Growth Model:

Suggested Solution:

Ke( Required rate of return)

= D1/Po + g

= $0.15(1+0.1) / $3-(0.15x$3) + 0.1

= $0.165/2.55+0.1

=0.165

=16.5%

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