A firm has 750,000 preferred shares outstanding.Each share has a stated dividend amount of $1.65 per share and are currently priced to yield 7.5%.What is the cost of the preferred shares if the firm's income tax rate is 27% and flotation costs on any new preferred share issue will be 2% before tax?

Question

Quizplus · Accepted Answer

First, let's calculate the before-tax cost of preferred shares:

Dividend yield = $1.65 / current price per share
0.075 = $1.65 / current price per share
Current price per share = $1.65 / 0.075 = $22

Therefore, the before-tax cost of preferred shares is:

Before-tax cost = $1.65 / $22 = 0.075 or 7.5%

Now let's calculate the after-tax cost of preferred shares, taking into account the firm's income tax rate and flotation costs:

Flotation costs before tax = 2%
Flotation costs after tax = (1 - 0.27) * 2% = 1.46%

After-tax cost = Before-tax cost / (1 - Flotation costs after tax)
After-tax cost = 7.5% / (1 - 1.46%) = 7.61%

Therefore, the after-tax cost of preferred shares is 7.61%. The best choice is B.

A Firm Has 750,000 Preferred Shares Outstanding