A firm's preferred stock pays an annual dividend of $2, and the stock sells for $65. Flotation costs for new issuances of preferred stock are 5% of the stock value. What is the after-tax cost of preferred stock if the firm's tax rate is 30%?

Question

Quizplus · Accepted Answer

The cost of preferred stock can be calculated using the following formula:

Cost of preferred stock = Preferred stock dividend / Net issuing price

Net issuing price = Stock price - Flotation costs

Flotation costs = 5% x $65 = $3.25

Net issuing price = $65 - $3.25 = $61.75

Cost of preferred stock = $2 / $61.75 = 3.23%

After-tax cost of preferred stock = Cost of preferred stock x (1 - Tax rate)

After-tax cost of preferred stock = 3.23% x (1 - 0.30) = 2.26%

Therefore, the after-tax cost of preferred stock is 2.26%, which is closest to option C (3.20%).

A Firm's Preferred Stock Pays an Annual Dividend of $2