4. The calculation of the cost of preferred stock

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 Peaceful Book Binding Company

Peaceful Book Binding Company has preferred stock that pays a dividend of $5 per share and sells for $100 per share. It is considering issuing new shares of preferred stock. These new shares incur an underwriting (or flotation) cost of 2.5%.

How much will Peaceful Book Binding Company pay per share to the underwriter?

$2.50 per share

$97.50 per share

$87.75 per share

$2.75 per share

Based on this information, what is Peaceful Book Binding Companys cost of preferred stock capital?

5.13%

5.64%

4.62%

4.36%

Companies SHOULD/SHOULD NOT make tax adjustments when calculating the (after-tax) cost of preferred stock because preferred dividends ARE/ARE NOT tax deductible, so the company bears their full cost.