To find the net proceeds from sale of the new common stock, we need to take into account under pricing and flotation cost.
The reasons a common stock needs to be under priced include the fact that investors often believe that company only issues new common stock when management feels that common stock is over priced. Therefore, investors will require lower price.
Another reason is that there is an equilibrium in the market and to sale more common stock than usual company needs to sale it at a lower price (by lowering price it will increase demand).
To find the cost of issuing new common stock, we can adjust the Gordon model (rs = (D1/Po) + g). Instead of Po which stands for price of share, we will use Nn which stands for net proceeds from the sale of new common stock share. Net proceeds is what we have left after subtracting underpricing and flotation costs. Therefore, the adjusted Gordon model formula to find cost of new issues of common stock is as follows:
Because dividends on common stock paid out of the after-tax earnings, no tax adjustment is required. The issue of new common stock is generally the most expensive source of long-term financing available.