Question

Given the following data:

• The firm’s marginal tax rate is 21%.

• The current price of the corporation’s 10% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,011.55. The company does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

• The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $110.12. The company would incur flotation costs of $3 per share on a new issue.

• The company’s common stock is currently selling at $55 per share. Its last dividend (D0) was $4.99, and dividends are expected to grow at a constant rate of 4.8% in the foreseeable future. The company’s beta is 1.1, the yield on Treasury bonds is 4%, and the market risk premium is estimated to be 7%. For the bond-yield-plus-risk-premium approach, the firm uses a four percentage point risk premium.

• Up to $300,000 of new common stock can be sold at a flotation cost of 15%. Above $300,000, the flotation cost would rise to 25%.

• The company’s target capital structure is 30 %long-term debt, 10% preferred stock, and 60% common equity.

• The firm is forecasting retained earnings of $300,000 for the coming year. Answer the following question:

c. (1) What is the firm’s cost of preferred stock?

(2) The company’s preferred stock is riskier to investors than its debt, yet the yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes.)

Answer 1