CFA Level ICorporate IssuersHard
Quantum Materials Inc. is issuing new common equity to fund a project. The stock currently trades at $50 per share, and the firm expects to pay a dividend of $3.00 per share next year, growing at a constant rate of 6% thereafter. The investment bank will charge flotation costs equal to 5% of the issue price. Using the flotation-cost-adjusted dividend discount model approach, what is Quantum's cost of new common equity?
- A13.16%
- B12.00%
- C12.32%
- D12.63%
Show answer & explanationAnswer & explanation
Correct answer: C. 12.32%
Net proceeds per share after flotation = $50 × (1 − 0.05) = $47.50. Cost of new equity = D1/[P0(1−F)] + g = $3.00/$47.50 + 0.06 = 0.0632 + 0.06 = 12.32%. This is higher than the cost of equity computed without flotation adjustment ($3/$50 + 6% = 12.00%), reflecting the additional cost of raising external equity capital.
Why the other options are wrong
- A. Significantly overstates cost; not consistent with a 5% flotation adjustment.
- B. This ignores flotation costs entirely (uses $50 gross price).
- D. Overstates the flotation cost impact by using an incorrect denominator.
Flotation-Adjusted Cost of New Equity
When issuing new common equity, flotation costs reduce net proceeds, which raises the effective cost of equity above the cost implied by the current market price.
- Formula: re = D1/[P0(1-F)] + g
- F is flotation cost as a percentage of issue price
- Flotation costs increase the required cost of new external equity relative to internal equity (retained earnings)
Memory trick: Fees shrink the pot — divide by what's left after flotation.