The stock of Gao Computing sells for $50, and last years dividend was $2.10. A flotation cost of 10% would be required to issue new common stock. Gaos preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 7% a year. The firm can issue additional long-term debt at an interest rate (or a before-tax cost) of 10%, and its marginal tax rate is 25%. The market risk premium is 6%, the risk-free rate is 6.5%, and Gaos beta is 0.83. In its cost-of-capital calculations, Gao uses a target capital structure with 30% debt, 10% preferred stock, and 60% common equity.

a) Calculate the cost of each capital componentin other words, the after-tax cost of debt, the cost of preferred stock (including flotation costs), and the cost of equity (ignoring flotation costs). Use both the CAPM method and the dividend growth approach to find the cost of equity.

b) Calculate the cost of new stock using the dividend growth approach.

c) What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as determined by the dividend growth approach and then add that difference to the CAPM value for rs.)

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