Chapter 10 The Cost of Capital 319Here F is the percentage! otation cost required to sell the new stock, so P 0 (1 " F) is
the net price per share received by the company.
Assuming that Allied has a " otation cost of 10%, its cost of new common
equity, re, would be computed as follows:
re! (^) $23.06(1 ___$1.25 (^) # (^) 0.10) " 8.3%
! (^) $20.75__$1.25 " 8.3%
! 6.0% " 8.3 %! 14.3%
This is 0.6% higher than the previously estimated 13.7% DCF cost of equity, so the
! otation cost adjustment is 0.6%:
Flotation adjustment! Adjusted DCF cost # Pure DCF cost! 14.3% # 13.7%! 0.6%
The 0.6% adjustment factor can be added to the previously estimated rs =
13.5% (Allied management’s estimate), resulting in a cost of equity from new com-
mon stock, or external equity, of 14.1%:
Cost of external equity! rS " Adjustment factor! 13.5% " 0.6%! 14.1%
If Allied earns 14.1% on funds obtained from selling new stock, the investors who
purchased that stock will end up earning 13.5%, their required rate of return, on
Flotation Cost, F
The percentage cost of
issuing new common
stock.
Flotation Cost, F
The percentage cost of
issuing new common
stock.
Flotation Cost
Adjustment
The amount that must be
added to rs to account for
flotation costs to find re.
Flotation Cost
Adjustment
The amount that must be
added to rs to account for
flotation costs to find re.
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