Determiningthe Cost of Capital: Cost of New Common Stock

If a firm plans toissue new stock, flotation costs (investment bankers' fees) shouldnot be ignored. There are two approaches to use to account forflotation costs. The first approach is to add the sum of flotationcosts for the debt, preferred, and common stock and add them to theinitial investment cost. Because the investment cost is increased,the project's expected return is reduced so it may not meet thefirm's hurdle rate for acceptance of the project. The secondapproach involves adjusting the cost of common equity asfollows:

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The difference between the flotation-adjusted cost of equity andthe cost of equity calculated without the flotation adjustmentrepresents the flotation cost adjustment.

QuantitativeProblem: Barton Industries expects next year's annualdividend, D₁, to be $2.00 and it expects dividends togrow at a constant rate g_L = 4%. The firm's currentcommon stock price, P₀, is $21.90. If it needs to issuenew common stock, the firm will encounter a 4.9% flotation cost, F.Assume that the cost of equity calculated without the flotationadjustment is 12% and the cost of old common equity is 11.5%. Whatis the flotation cost adjustment that must be added to its cost ofretained earnings? Round your answer to 2 decimal places. Do notround intermediate calculations.
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What is the cost ofnew common equity? Round your answer to 2 decimal places. Do notround intermediate calculations.
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