4. Firms that carry preferred stock in their capital mix want to not only distribute dividends to the companys 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 Inc.

The CFO of Purple Lemon Shipbuilders Inc. has decided that the company needs to raise additional capital. It can sell preferred stock paying an annual $5 dividend per share for $100 per share; however, it will incur a flotation cost of 2.5% per share.

After it pays the underwriter, Purple Lemon Shipbuilders Inc. will receive from each share of preferred stock that it issues. Options 87.75, 97.50, 2.50, 2.13

Based on this information, Purple Lemon Shipbuilders Inc.s cost of preferred stock is Options 5.64, 4.10, 4.87, 5.13

When raising funds by issuing new preferred stock, the company will incur an underwriting, or flotation, cost that. Increase / Decreases the cost of preferred stock. Because the flotation cost is usually expressed as a percentage of price of each share, the difference between the cost of preferred stock with and without flotation cost is. Insignificant / Significant enough to not ignore.

The cost of debt that is relevant when companies are evaluating new investment projects is the marginal cost of the new debt to be raised to finance the new project.

Consider the case of Happy Lion Manufacturing Inc. (Happy Lion):

Happy Lion Manufacturing Inc. is considering issuing a new 20-year debt issue that would pay an annual coupon payment of $70. Each bond in the issue would carry a $1,000 par value and would be expected to be sold for a price equal to its par value.

Happy Lions CFO has pointed out that the firm would incur a flotation cost of 1% when initially issuing the bond issue. Remember, the flotation costs will be Subtracted from / added to the proceeds the firm will receive after issuing its new bonds. The firms marginal federal-plus-state tax rate is 45%.

To see the effect of flotation costs on Happy Lions after-tax cost of debt (generic), calculate the after-tax cost of the firms debt issue with and without its flotation costs, and select the correct after-tax costs (in percentage form):

After-tax cost of debt without flotation cost:

Options 3.2725, 3.8500, 4.2350, 4.0425

After-tax cost of debt with flotation cost:

Options 3.6575, 3.9023, 4.620, 4.4275

This is the cost of Embedded / new debt, and it is different from the average cost of capital raised in the past.