A firm has an issue of preferred stock that pays an annual dividend of $2.00 per share and currently is selling for $18.50 per share. Finally, the firm's marginal tax rate is 34%. This firm's cost of financing with new preferred stock is

Question

Quizplus · Accepted Answer

The cost of financing with preferred stock is calculated using the formula:

Cost of preferred stock = Dividend / Net proceeds

Where:
Dividend = Annual dividend per share
Net proceeds = Price per share - Flotation costs per share

In this case, the annual dividend per share is $2.00 and the price per share is $18.50. However, the problem doesn't provide information about any flotation costs, so we'll assume that there are none.

Net proceeds = $18.50 - $0 = $18.50

Therefore, the cost of financing with preferred stock is:

Cost of preferred stock = $2.00 / $18.50 = 0.1081 or 10.81%

However, we also need to factor in the firm's marginal tax rate. Preferred stock dividends are not tax-deductible, so the after-tax cost of financing with preferred stock is:

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

After-tax cost of preferred stock = 10.81% x (1 - 0.34) = 7.13%

Therefore, the best choice is C, 10.81%.

A Firm Has an Issue of Preferred Stock That Pays