Question 3 (a)
Is the cost of existing and of new share capital the same?
3 marks
- Time to write
- About 6 minutes
- Topic
- Cost of capital
Question
Question 3 (a) · 3 marksThe cost of existing share capital and of a fresh issue of capital is the same in every case. Do you agree? Why?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Do you agree?…?A yes-or-no question: answer it in your first line, then explain why.
- WhyReasons, not a description: each reason explained in a line or two.
Write it in this order
- 1 Answer: not the same 1 mark 2 min
- 2 Market price versus net proceeds; flotation costs 2 marks 4 min
Try it first. About 6 minutes for 3 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
No, I do not agree. The cost of a fresh issue of equity is normally higher than the cost of the existing equity.
- Different base. The cost of existing equity is measured on the current market price of the share (ke = D1 ÷ MP + g), while the cost of a new issue is measured on the net proceeds the firm actually receives from each new share (ke = D1 ÷ NP + g).
- Flotation costs. A new issue involves flotation costs (underwriting, brokerage, issue expenses), and shares are often issued below the market price. The net proceeds are therefore lower than the market price, so the same dividend stream represents a higher cost for new capital.
- Example (data of the DU text's illustration; figures worked here): with a dividend of ₹10, growth of 5% and an issue at ₹100 with flotation costs of 5% of the price, the new issue costs 10 ÷ 95 + 5% = 15.53%, whereas existing shares priced at ₹150 cost 10 ÷ 150 + 5% = 11.67%.
The two costs are the same only in the special case where there are no flotation costs and the new shares are issued at the current market price.
Where the 3 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Answer: not the same | 1 |
| 2 | Market price versus net proceeds; flotation costs | 2 |
| Total | 3 |
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