Component Cost of Preferred Stock

Component Cost of Preferred Stock

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Question

Consider the following information for a company.

Common Stock Price $75.50 -

Preferred Stock Par Price $100 -

Preferred Dividend $4.0 -

Debt Rating BB+

Owners Equity 12.27%

Preferred Stock Flotation Cost 2.0%

The Preferred Stock is issued at Par

Calculate the component cost of this newly issued preferred stock.

Answers

Explanations

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Explanation

The component cost of preferred stock is the dividend divided by issue price minus floatation cost. In this case the component cost of preferred stock = $4.00 /

(100 - 2) = 4.08%.

To calculate the component cost of newly issued preferred stock, we need to determine the required rate of return or the cost of equity for the preferred stock.

The cost of preferred stock is calculated using the formula:

Cost of Preferred Stock = Preferred Dividend / Preferred Stock Price

In this case, the preferred dividend is given as $4.0, and the preferred stock price is the par value, which is $100. Therefore, the cost of preferred stock is:

Cost of Preferred Stock = $4.0 / $100 = 0.04 or 4.0%

However, the question mentions that the preferred stock has a flotation cost of 2.0%. Flotation cost is the cost incurred by a company when issuing new securities. Since the preferred stock is issued at par, the flotation cost is 2.0% of the preferred stock price.

Flotation Cost = 2.0% * $100 = $2.0

To adjust for the flotation cost, we need to subtract it from the preferred dividend, as the company has to pay this amount upfront. Therefore, the adjusted preferred dividend is:

Adjusted Preferred Dividend = Preferred Dividend - Flotation Cost = $4.0 - $2.0 = $2.0

Now we can recalculate the cost of preferred stock using the adjusted preferred dividend:

Cost of Preferred Stock = Adjusted Preferred Dividend / Preferred Stock Price = $2.0 / $100 = 0.02 or 2.0%

Therefore, the component cost of the newly issued preferred stock is 2.0%. However, none of the given answer choices match this result, so it's possible that there may be an error in the question or answer options.

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