Cost of Equity with Flotation Cost
Date: June 10, 2008 12:29PM
Hi, the adjusted cost of equity formula shows below:
r = D1/P0 (1 - f) + g
See volume 4 book page 68. However, the examples showed afterwards seem inconsistent.
Example 1. Suppose a company pays current dividend $2/share and price is $40/share. Expected growth rate is 5%. If the flotation costs are 4% of the issurance, what would be the cost of equity?
The books shows:
r of equity without floatation = [$2(1+5%)/$40] + 5% = 10.25%
r of equity = [$2(1+5%)/$40(1-4%)] + 5% = 10.47%
Right after this example, on page 69. With Euro $2 dividend and Euro $20 /share, expected growth rate is 5%. By using the same dividend discount model without considering floatation costs, the book states:
r = 2/20 + 5%
Ok. I'm wondering why the first example considers the growth rate as a factor to its dividend while the second example did not? What should I do in real exam???
Date: June 10, 2008 12:33PM
the one with the adjusted cost is the incorrect treatment of floatation cost and the later one is correct treatment of floation cost, as we use the the unadjusted cost to calculate NPV of the project. CFAI LOS says "Correct treatment" example is given to make a sense of incorrect treatment.
Date: June 10, 2008 04:38PM
Well, "correct treatment vs. incorrect treatment"
You are talking about the floatation costs adjustment as initial cash flow instead of incorporating it into the cost of capital, right? I know the preferred approach is to deduct it from NPV.
However, the question I showed here is about the growth rate adjustment for the dividend.
You see the forumla says r = D1/P0 (1 - f) + g; yet the example calculates using
r = D1(1+g)/P0(1 - f) + g; why the dividend part be treated differently??? The book does not explain. Which way I'll use to calculate?
Date: June 11, 2008 06:14AM
The books showed it as incorrect treatment ... and then it explains the correct ... do in exam dont do it ...
Date: June 15, 2008 01:44PM
Thanks for your clarification and help, madanaylyst.
I understand the best approach is to use NPV when considering flotation costs.
What if they require to calculate cost of equity by using Dividend Discounted Model???
Then which of the following should I use? Our book give us the formula of 1) yet calculates the example by formula 2). I guess that's where my confusion comes from.
1) r = D1/P0 (1 - f) + g vs. 2) r = D1(1+g)/P0(1 - f) + g
Date: June 15, 2008 03:28PM
I got it. Thanks again, madanalyst.