CFA Practice Question

There are 233 practice questions for this study session.

CFA Practice Question

WC Ltd. is a constant growth company that expects to grow at 5% and plans to raise some equity. The current stock price for the company is $45 and the company is expected to pay a dividend of $4 next period. What is the cost of the new equity if flotation costs are 10% of the issue?

A. 5%
B. 9.88%
C. 14.88%
Correct Answer: C

4/[45(1-0.10)] + 0.05 = 14.88

User Contributed Comments 11

User Comment
surob What is the floatation cost?
kameta0bp The costs associated with the issuance of new securities.

Flotation costs include both the underwriting spread and the costs incurred by the issuing company from the offering. Expressed as a portion of gross proceeds, costs generally increase as risks associated with the issue increase, or the size of the offering decreases.
johnowens In Schweser they say Floatation costs are NOT part of cost of capital.This is incorrect, the above is right.

The presence of flotation costs raise the cost of new equity capital
shiva5555 Why do you take the flotation price out of the current price instead of the whole equation?
joywind I personally believe that the reason of using P/(1-flotation rate) is because Price available on the market is the one already adjusted after the flotation costs, but not the whole value that stock holders expect to get, so we need to adjust the Price back to the value P/(1-flotation rate) expected to obtained by the stock holders... correct me if i am wrong.
dipu617 Could anyone please tell me which formula was used for the equation?
hoyleng dipu617 : DDM formula was used for the equation..
rinpanay Expected Return = [D1/P0(1-F)] + g
where D1=Dividend Paid, P0=Stock Price, F=Floating Rate, g= growth rate
SWhip Pg. 71 of the CFA book says it is incorrect.

Starting second paragraph

"The problem with this approach is that flotation costs are a cash flow at the initiaton of the project and affect the value of any project by reducing the initial cash flow. Adjusting the cost of capital for flotation costs is INCORRECT..."
khalifa92 the whole idea of floatation cost is that you have to deduct it from the stock price to find a required rate of return closer to reality.,
Kiniry @SWhip is correct. If you include flotation costs as a part of your WACC, you will incorrectly calculate NPV. Flotation costs are included in the initial cash outflow for the investment because they are incurred immediately.

Because these are one time events, if you fail to include them in the original outflow and instead use a higher cost of capital, you will overestimate NPV.
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