A firm has an issue of preference shares 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 preference shares is

Question

Quizplus · Accepted Answer

The cost of financing with new preference shares can be calculated using the following formula:
Cost of preferred stock = Annual dividend / Net proceeds per share

Annual dividend = $2.00
Net proceeds per share = Selling price per share * (1 - Marginal tax rate)
Net proceeds per share = $18.50 * (1 - 0.34)
Net proceeds per share = $12.19

Cost of preferred stock = $2.00 / $12.19
Cost of preferred stock = 0.164 or 16.4%
However, since the dividend from preferred shares is tax-deductible, we need to calculate the after-tax cost of preferred stock.

After-tax cost of preferred stock = Cost of preferred stock * (1 - Marginal tax rate)
After-tax cost of preferred stock = 16.4% * (1 - 0.34)
After-tax cost of preferred stock = 10.81%

Therefore, the cost of financing with new preference shares is 10.81%, which corresponds to choice letter C.

A Firm Has an Issue of Preference Shares That Pays