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 calculate the cost of new equity for Wheel, we need to find the cost of equity, also known as the required rate of return. This is the return that investors require for investing in the company's stock.
The cost of equity (Ke) can be calculated using the Gordon Growth Model (also known as the dividend discount model). The formula is:
Ke = (D1 / P0) + g
Where:
D1 = Expected dividend per share in the next period
P0 = Current stock price per share
g = Dividend growth rate
In this case, Wheel has just paid a dividend of $2.50 per share. The dividends are expected to grow at a constant rate of 6% per year forever. The current stock price is $50 per share.
D1 = $2.50 * (1 + 0.06) = $2.65 (Expected dividend next year)
P0 = $50 (Current stock price)
g = 0.06 (Dividend growth rate)
Ke = ($2.65 / $50) + 0.06 = 0.053 + 0.06 = 0.113 or 11.3%
So, the cost of new equity for Wheel is 11.3%.
Advantages of using equity financing for the firm:
1. No obligation to repay: Unlike debt financing, equity financing does not come with the requirement to make regular interest or principal payments. This can provide financial flexibility to the firm.
2. Sharing risk: By issuing equity, the firm shares ownership and risk with shareholders. If the firm faces financial difficulties, the burden is shared among equity holders.
3. Increased credibility: Having equity investors can enhance the perceived credibility and reputation of the firm, making it easier to attract financing and investment opportunities.
Disadvantages of using equity financing for the firm:
1. Dilution of ownership: Issuing new equity means giving up partial ownership of the firm to shareholders. This dilution of ownership can lead to loss of control for existing shareholders.
2. Potential conflicts: Having multiple shareholders may result in differing opinions and conflicts regarding company direction and decision-making.
3. High cost: Equity financing may come at a higher cost compared to debt financing. Investors require a higher return on their investment due to the risk and potential for loss associated with equity investments.
These advantages and disadvantages should be considered by Wheel when deciding whether to pursue equity financing for the firm.