Question

10. Yasemin Hilfiger has just issued a callable preferred stock that is callable in 6 years at $70 (redemption price). The stock is currently selling for $60 (issue price) but there will be $3 issuance costs per share. Everyone including the company and its investors are expecting that the stock will be called at that time. What is the after-tax cost of this preferred stock assuming it is called, if the stock pays $6 in dividends annually and the marginal tax rate is 40%? (Points : 3)

       13.24%
       7.95%
       12.96%
       18.09%

Answer 1

CALCULATION OF AFTER TAX COST OF PREFERRED STOCK

NOTE:- DIVIDENDS ARE PAID FROM AFTER TAX PROFITS SO WE NEED NOT TAKE TAX RATE IN THIS PROBLEM

K_PS = [D+ (RV-NP)/n]/[1/2(RV+NP)]

D = ANNUAL DIVIDEND = 6

RV = REDEMPTION VALUE AT THE TIME OF CALL = 70

NP = NET PROCEEDS = ISSUE PRICE - ISSUANCE COST = 60-3 = 57

n = NUMBER OF YEARS TO CALL

K_PS = [D+ (RV-NP)/n]/[1/2(RV+NP)] = [6+(70-57)/6]/[1/2(70+57) = [6+13/6]/[0.5*127]

= [6+2.167]/[63.5] = 8.167/63.5 = 0.1286 = 12.86%

AFTER TAX COST OF PREFERRED STOCK = 12.86%

AS PER THE QUESTION NEAREST OPTION IS 12.96%