Cost of External Equity Calculator

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Reviewed by David Chen, CFA.

Use this Cost of External Equity Calculator to determine the required rate of return that a company must earn on the portion of its projects financed with new common stock, taking into account the costs associated with issuing new equity (flotation costs).

Cost of External Equity Calculator

Calculated Cost of External Equity
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Detailed Calculation Steps

Enter values and click Calculate to see the steps.

Cost of External Equity Calculator Formula

The cost of external equity ($R_{ne}$) is derived from the Dividend Growth Model (Gordon Growth Model), adjusted for the flotation costs associated with issuing new stock.

$$R_{ne} = \frac{D_1}{P_0(1-F)} + g$$

Formula Source: Corporate Finance Institute (Cost of Equity) | Investopedia (Flotation Cost)

Variables

Here is an explanation of the variables required for the calculation:

  • Current Dividend per Share ($D_0$): The most recently paid dividend.
  • Current Market Price per Share ($P_0$): The current trading price of the stock.
  • Expected Growth Rate of Dividends ($g$): The expected annual percentage growth rate of the dividends (as a decimal in the formula).
  • Flotation Cost Percentage ($F$): The total cost (in percentage terms) incurred by the company to issue and sell new common stock.
  • Next Expected Dividend ($D_1$): Calculated as $D_0 \times (1+g)$.

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What is the Cost of External Equity?

The cost of external equity ($R_{ne}$), sometimes called the cost of new common stock, represents the rate of return a company must generate on new projects to satisfy its new investors. It is an important input for calculating the firm’s Weighted Average Cost of Capital (WACC).

Unlike the cost of retained earnings ($R_e$), the cost of external equity is always higher. This difference is due to the **flotation costs** ($F$)—fees paid to investment bankers, legal costs, printing, and distribution expenses—incurred when issuing new stock. These costs effectively reduce the net proceeds the company receives from selling the stock, requiring the company to achieve a higher return to break even and satisfy the dividend expectations of the new shareholders.

How to Calculate Cost of External Equity (Example)

Let’s calculate $R_{ne}$ for a company with the following details:

  1. Input Variables: Current Dividend ($D_0$) = $1.50, Stock Price ($P_0$) = $30.00, Growth Rate ($g$) = 6.0%, Flotation Cost ($F$) = 5.0%.
  2. Calculate Next Expected Dividend ($D_1$): $$D_1 = D_0 \times (1 + g) = \$1.50 \times (1 + 0.06) = \$1.59$$
  3. Calculate Net Proceeds ($P_{net}$): Flotation costs reduce the price received: $$P_{net} = P_0 \times (1 – F) = \$30.00 \times (1 – 0.05) = \$28.50$$
  4. Apply the External Equity Formula: $$R_{ne} = \frac{D_1}{P_{net}} + g = \frac{\$1.59}{\$28.50} + 0.06$$
  5. Final Calculation: $$R_{ne} = 0.055789 + 0.06 = 0.115789 \text{ or } 11.58\%$$

Frequently Asked Questions (FAQ)

What is the difference between the Cost of External Equity ($R_{ne}$) and the Cost of Retained Earnings ($R_e$)?

The core difference is the inclusion of flotation costs ($F$). The Cost of Retained Earnings uses the current market price ($P_0$) directly in the denominator, while the Cost of External Equity subtracts flotation costs from the price, leading to a higher required rate of return.

Why are flotation costs included in the calculation?

Flotation costs represent a cash outflow that reduces the net capital raised by the company. To cover these costs and still provide the expected return to investors, the new capital must generate a higher return, hence the increased cost of external equity.

Can the growth rate ($g$) be negative?

While theoretically possible, a constant negative growth rate would imply a perpetually shrinking company, which often means the Dividend Growth Model is inappropriate. For practical corporate finance applications, the model typically assumes a stable, positive growth rate.

What model is the Cost of External Equity based on?

It is based on the Dividend Growth Model (DGM), also known as the Gordon Growth Model (GGM). This model assumes that the stock’s value is the present value of all future dividends, which are expected to grow at a constant rate.

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