Solved Question: A company plans to float $25 million in bonds

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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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