4. 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 Purple Lemon Shipbuilders Inc.

Purple Lemon Shipbuilders Inc. 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 2.2%.

How much will Purple Lemon Shipbuilders Inc. pay per share to the underwriter?

A. $2.42 per share

B. $88.02 per share

C. $97.80 per share

D. $2.20 per share

Based on this information, what is Purple Lemon Shipbuilders Inc.s cost of preferred stock capital?

A. 4.34%

B. 4.09%

C. 5.62%

D. 5.11%

FILL IN THE BLANKS:

Companies ________ (should or should not) make tax adjustments when calculating the (after-tax) cost of preferred stock because preferred dividends ______ (are or are not) tax deductible, so the company bears their full cost.