A firm has $5 million in retained earnings. The market price of the firm's common stock is $55. The firm recently paid a dividend of $3.70. Earnings and dividends are expected to increase at an annual rate of 9 percent. When new common stock is issued, flotation costs amount to 4 percent of market price. What is the firm's cost of external equity financing?

Cost of external equity financing 16.64%

Explanation:

Cost of external equity financing=Div * (1+g) / P (1-F) + g

F = the percentage flotation cost=4%

Div=Dividend in the current period=$3.7

g=growth=9%

P=Market price of the stock = $55

Cost of external equity financing=3.7 * (1+0.09) / (55 * (1-0.04)) + 0.09=0.166383=16.64%

cost of external equity financing = 16.64%

Explanation:

Cost of equity finance can be calculated using the formula mentioned below.

ke = {d (1+g) : p} + g

ke = cost of equity

d = dividend per share

g = growth rate

p = market price per share

ke = {$3.70 (1.09) : $55 * (1-0.04) } + 0.09

ke = 16.64%

Interpretation of the formula:

Equity represents a piece of stake and/or ownership, the holder of it is considered to be it's owner. Every investor expects some return on their investment therefore the return on equity/shares is the dividend received by owners which is in turn the cost bore by the business.

The formula simply is a percentage representation of the dividend paid (which is the cost of finance to the business) on investment in one share. And the growth factor is also added if dividend paid grows each year.