$5$ EXAMPLE

If Allied incurred a flotation cost of $10\%$ for issuing new stock, how much higher would its

cost of equity from new common stock be than its cost of retained earnings?

Using the DCF method, Investors require a return of $10\mathrm{.}7\%$ on the money they invest.

However, the firm will receive less than investors invest due to flotation costs, so it must earn

more than $10\mathrm{.}7\%$ to provide that return to investors. It turns out that if the firm can earn

$11\mathrm{.}3\%$ on the funds it receives, it can provide the $10\mathrm{.}7\%$ required by investors.

Alternatively, flotation costs could have been expressed as a dollar amount. In that

scenario, we would have been told that the issuance of new common stock carried a

flotation cost of $$2\mathrm{.}31$ per share of stock. On that basis we could have calculated the cost of

new common stock by adjusting the price in the following manner, $P_0-$$$F.$