4. Cost of external equity
Cost of newly issued stock (kc) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common stock). For a constant-growth company, this can be calculated as follows:

Formula 11.7

kc= D1__ + g
       P0 (1-F)

where:
F = the percentage flotation cost, or (current stock price - funds going to company) / current stock price

Example: cost of newly issued stock
As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco's cost of new equity?

Answer:
kc      2       + 0.07 = 0.123, or 12.3% 
      40(1-0.05)

It is important to note that the cost of newly issued stock is higher than the company's cost of retained earnings. This is due to the flotation costs.



Target Capital Structure

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