Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of six percent per year forever. If the stock is currently selling for $50 per share with a 10% flotation cost, what is the cost of new equity for the firm? What are the advantages and disadvantages of using this type of financing for the firm?
To find the cost of new equity for the firm, we need to use the dividend growth model formula. The formula is as follows:
Cost of Equity = Dividend per Share / Current Stock Price + Dividend Growth Rate
Given:
- Dividend per share = $2.50
- Current stock price = $50
- Dividend growth rate = 6%
Using these values, we can now calculate the cost of new equity:
Cost of Equity = $2.50 / $50 + 6% = 0.05 + 0.06 = 0.11 or 11%
Therefore, the cost of new equity for the firm is 11%.
Now let's discuss the advantages and disadvantages of using this type of financing, which is equity financing, for the firm:
Advantages:
1. No Obligation to Repay: Unlike debt financing, where the firm needs to repay principal and interest, equity financing does not create any financial obligations for the firm to repay a specific amount. This can provide greater financial flexibility.
2. Shared Risk and Ownership: Equity financing involves selling ownership shares in the firm. This means that investors bear a portion of the risk associated with the firm's operations, and their interests are aligned with the firm's success. Additionally, having multiple shareholders can bring diverse perspectives and expertise to the company.
3. No Interest Payments: Equity financing does not require the firm to make periodic interest payments, which can reduce the pressure on cash flows during challenging periods.
Disadvantages:
1. Dilution of Ownership: Issuing new equity can dilute the ownership of existing shareholders. This means that they will own a smaller percentage of the company, and their control and decision-making power may decrease.
2. Cost of Equity: Compared to debt financing, the cost of equity financing tends to be higher. This is because equity investors require a higher return on their investment to compensate for the greater risk they assume. This can increase the firm's cost of capital.
3. Loss of Information Privacy: When a firm goes public and issues equity, it becomes subject to various disclosure requirements and regulations. This leads to a loss of privacy and may require the company to disclose sensitive financial and operational information to the public.
It is important for a firm to carefully consider its financial situation, capital structure goals, and the potential impact on ownership and control before deciding to use equity financing.