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COST OF

COMMON STOCK
FERNANDO, Clarence P.
BSA 3A
TWO FORMS OF COMMON
STOCK FINANCING
1) Retained Earnings/ Internal
Common Equity
2) New issues of common stock/
External Common Equity
COST OF
COMMON STOCK
The return that investors
holding shares in a firm
require.
Finding the Cost of
Common Stock Equity
Constant-growth valuation
(Gordon Growth) model
Capital asset pricing model
(CAPM)
Finding the Cost of Common Stock
Equity: Using the Constant-growth
valuation (Gordon Growth) model
Per-share dividend
Value of Assumes that dividends expected at the
end of year 1
Common stock will grow at a constant
rate.

Required return Constant rate of


on common stock growth in dividends
Example
ABC Corporation wishes to determine its cost of common stock equity.
The market price of its common stock is 50 per share. The firm expects
to pay a dividend of 4 at the end of the coming year and the annual
growth rate of dividends is 5%. Calculate the required rate of return.

= 4 = 5% =50 =?

rs = 4
50 + 0.05

rs = 13%
Finding the Cost of Common Stock Equity:
Using the Capital Asset Pricing Model
(CAPM) Market risk premium

Describes the relationship


between the required return and
the non-diversifiable risk of the
firm.
required risk-free rate beta market
return of return coefficient return
Example
ABC Corporation now wishes to calculate its cost of
common stock equity by using the CAPM. The firms beta
equals 1.5, the risk-free rate equals 7% and the market
return equals 11%.
= 1.5 = 7% = 11% =?

rs =7% +[1.5(11% 7%)]


=7% + 6%
rs = 13%
Two Forms Of
Common Stock
Financing
Two Forms Of Common Stock Financing:
The Cost Of Retained Earnings

Cost of retained earnings is the


same as the cost of an equivalent
fully subscribed issue of
additional shares.
ABC Corporation

= 13%
Two Forms Of Common Stock
Financing: The Cost Of New issues of
common stock

The cost of a new issue of common stock is


determined by calculating the cost of common
stock, net of underpricing and associated
flotation costs.
Two Forms Of Common Stock
Financing: The Cost Of New issues of
common stock
Expected dividend

Cost of a
new issue Expected
of common growth rate
stock of dividends

Net proceeds from the sale of common


stock after underpricing and flotation
costs
Example
To determine its cost of new common stock, rn, ABC
Corporation has estimate that on average, new shares can
be sold for 47. The 3 per-share underpricing is due to the
competitive nature of the market. A second cost associated
with a new issue is flotation costs of 2.50 per share that
would be paid to issue and sell the new shares. The total
underpricing and flotation cost per share are therefore 5.50.
(3 + 2.50) Subtracting the 5.50 per share underpricing and
flotation cost from the current 50 share price results in
expected net proceeds of 44.50 per share.
=4 = 44.50 = 5% =?

rn = 4.00
44.50 + 0.05

rn = 14%
rr = 13%

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rn = 14%