Question

Johnson & Johnson is considering a new project with a needed capital of $1,800,000. The company is using only debt and common equity (raised by selling new common stock) as a strategy to manage this capital. Part of this capital, which accounts for $720,000, is acquired from the bank at an interest rate of 10%. The applicable tax rate is 35%.
Assuming that flotation is likely to be 6%, the expected dividend received is $4, common stock presently sells for $64 per share, growth rate is 7% and the risk-free rate is 5.9%.

1. Assume the firm has decided to use also preferred stock for a total of $500,000 to raise capital noting that the stock would sell for $80 and pay a constant dividend of $2.7 per share. What would the cost and weight of preferred stock be, respectively? *

Answer 1

Weight and cost of preferred stock

Weight of preferred stock = Preferred capital/ total capital = 500,000/ 1,800,000 = 27.78%

Cost of preferred stock = Fixed dividend/ Net proceeds

= (Fixed Dividend )/ stock price- flotation cost)

Assumption 1: If flotation cost of 6% is also applicable to preferred stock

Kp = $2.7/($80-6%*$80) = $2.7 / $75.20 = 3.59%

Assumption 2: If flotation cost of 6% is not applicable to preferred stock

Kp = $2.7/($80) = $2.7 / $80 = 3.375%