Description
Solved Question:
A company plans to float $25 million in bonds and $10 million in preferred stock. The current price of it’s preferred stock is $50 and it pays $2.60 in preferred dividends, which is likely to continue for the next five years. The company’s investment banking firm will charge 5% for flotation fees to float these securities. The banking firm will sell the bonds with a 20-year maturity and a 6.5% annual coupon rate at par value. The company has a tax rate of 35%. What is the cost of preferred stock and debt to the company after taxes, taking into account the flotation costs?
choices are :
stock 5.9% bond 2.8%,
stock 5.5% bond 4.5%,
stock 4.65% bond 5.6%
stock 3.9% bond 4.1%
Answer
The correct answer is Stock 5.5% and Bonds 4.4%. | |
Calculation: | |
Cost of preferred stock = Preferred dividend/(Price*(1-f)) | |
where f=floatation cost | |
Substituting values we get cost of preferred stock = | |
= 2.6/(50*0.95) = | 5.5% |
Cost of debt = Interest*(1-t)/(SP*(1-f)), where t=tax rate, f=floatation cost and SP is selling price of the bond. | |
Substituting values we get cost of debt = | |
= 65*0.65/(1000*0.95) = | 4.4% |
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