Cost of Equity with Flotation Cost

[hyang]

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???

 

[madanalyst]

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.

 

[hyang]

Thx, madanalyst.

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?

Thanks,

-Hui

 

[madanalyst]

The books showed it as incorrect treatment ... and then it explains the correct ... do in exam dont do it ...

 

[hyang]

Thx, madanalyst.

So I'm going to use r = D1/P0 (1 - f) + g to calculate if taking flotation costs into account, correct?

 

[madanalyst]

no....

the correct treatment is using the NPV method to take floation costs into the account... adjusting cost of capital is "not correct". Using r = D1/(1-f) + g is not correct for floatation costs, NPV is correct.