The cost of new common stock is determined by adding flotation
costs to the cost of current equity.
LEARNING OBJECTIVE [ edit ]
Calculate the cost of new equity
KEY POINTS [ edit ]
If a mixture of internal and external sources of financing are used, a company must determine the
proportion of external financing to be used, and thus the marginal cost of capital.
Flotation costs include all costs of issuing the securities, such as banker's fees, legal fees,
underwriting fees, filing costs, etc.
Cost of new common stock is calculated using the dividend growth model, by devaluing the
current stock price by the amount of flotation cost.
TERM [ edit ]
Marginal Cost of Capital
The cost of the marginal dollar of capital that a firm could raise externally.
EXAMPLE [ edit ]
$10 in dividends are expected to be payed out during the year. The current price of the stock is
$100. The issuance of new stock is expected to incur flotation costs of 3%. The growth rate is
assumed to be 5%. The cost of new equity is 15.3%.
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The Cost of New CommonStock
When evaluating a new project, a company is presented with the decision of financing the
project using internal or external sources.
If a mixture of these sources is used, the
company must then decide
the proportion of internal versus external
sources that will be utilized, and
subsequently the marginal cost ofcapital.
If a company plans to issue new
common equity, or external equity, in
order to finance a new project, the cost of
that equity must be calculated and
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factored into the weighted average cost of
capital to be used during the evaluation process. The cost of external equity is higher than the
cost of existing equity, orretained earnings. We can determine how much higher the cost of
external equity will be by factoring in flotation cost.
Flotation Cost
Flotation costs include all costs of issuing the securities, such as banker's fees, legal fees,
underwriting fees, filing costs, etc. We can calculate the cost of new common stock using
the dividendgrowth model by simply devaluing the price of current common stock by the
amount of flotation costs.
Cost of New Equity
Cost of new equity equals dividends payed in year one divided by the current stock price, devalued
by the amount of flotation cost, plus the growth rate.
Another contributor to flotation cost is stock value dilution that arises from issuing new
shares into the market. The theoretical diluted price–the price after an increase in the
number of shares–can be calculated as , where SON is the original number of shares, SNN is
the new number of shares, SOP is the original share price, and SNP is the new share price.
Example Equation
$10 in dividends. Current price of $100. Flotation cost of 3%. Growth rate of 5%.