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

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:

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