Diggin Tools plans to issue new preferred stock, which has a market value of $85 per share. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. What Diggin's component cost of preferred stock, r_ps?

Question

Quizplus · Accepted Answer

rps = Annual dividend / Net issuing price

Net issuing price = Market value - Flotation costs

Net issuing price = $85 - ($85 x 0.06) = $79.90

rps = $9.35 / $79.90 = 0.11696 or 11.70%

However, we need to adjust for the tax savings from the dividends paid on preferred stock, which are tax-deductible for the company.

After-tax cost of preferred stock = rps x (1 - marginal tax rate)

After-tax cost of preferred stock = 0.11696 x (1 - 0.30) = 0.08187 or 8.19%

Therefore, the component cost of preferred stock for Diggin Tools is 11.70%, but the after-tax cost is 8.19%. The correct answer choice is D.

Diggin Tools Plans to Issue New Preferred Stock, Which Has