Firms that carry preferred stock in their capital mix want to not only distribute dividends to common stockholders but also maintain credibility in the capital markets so that they can raise additional funds in the future and avoid potential corporate raids from preferred stockholders.
Consider the case of Purple Lemon Shipbuilders:
Ten years ago, Purple Lemon Shipbuilders issued a perpetual preferred stock issue—called PS Alpha—that pays a fixed dividend of $7.50 per share and currently sells for $100 per share. Purple Lemon’s management team is considering issuing a second issue of perpetual preferred stock. If the new issue—tentatively called PS Beta—is actually sold, the company will incur an underwriting (or flotation) cost of 5.10%. In addition, the underwriters are anticipating the need to pay a dividend of $12.25 per share to attract new investors, and is expecting to sell the new shares for $104.00 per share.
A: 7.5% OR 6.38% OR 7.13% OR 7.88%
If Purple Lemon elects to issue its PS Beta shares, it will pay B: $4.77 OR $7.42 OR $5.30 OR $4.24 per share in flotation costs, and will receive net proceeds of C: $98.70 OR $78.96 OR $88.83 OR $138.18 per share from its underwriters.
Based on its underwriters’ best estimates of the issue’s expected future dividend and market price, the marginal cost of the PS Beta issue is expected to be:
D: 10.55% OR 12.41% OR 9.31% OR 14.72%
Companies E: Should OR Should not make tax adjustments when calculating the (after-tax) cost of preferred stock because preferred dividends F: are OR are not tax deductible, so the company bears their full cost.
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