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Chapter 10: Problem 14

Trivoli Industries plans to issue a \(\$ 100\) par perpetual preferred stock with an 11 percent dividend. It is currently selling for \(\$ 97.00\) but flotation costs will be 5 percent of the market price, so the net price will be \(\$ 92.15\) per share. What is the cost of the preferred stock, including flotation?

Short Answer

Expert verified
The cost of the preferred stock, including flotation, is approximately 11.94%.

Step by step solution

01

Identify the Dividend and Net Price

First, we need to identify the given dividend and net price. The perpetual preferred stock has a dividend yield of 11 percent on a par value of \(100, so the annual dividend is calculated as \( D = 0.11 \times 100 = \\) 11 \). The net price after flotation costs is given as \( \$ 92.15 \).
02

Calculate the Cost of Preferred Stock

The cost of preferred stock can be found by dividing the annual dividend by the net price after flotation costs. The formula is \( k_{ps} = \frac{D}{P_{net}} \), where \( k_{ps} \) is the cost of preferred stock, \( D \) is the dividend, and \( P_{net} \) is the net price per share. Plugging in the values, we have \( k_{ps} = \frac{11}{92.15} \).
03

Perform the Division

Compute the division from the previous step: \( k_{ps} = \frac{11}{92.15} \approx 0.1194 \).
04

Convert to Percentage

Convert the decimal to a percentage to express the cost of preferred stock. Thus, \( 0.1194 \) as a percentage is \( 11.94\% \).

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Dividend Yield
Dividend yield is a crucial concept when discussing preferred stocks. Simply put, the dividend yield is the dividend per share, expressed as a percentage of the stock's par value. In this case, Trivoli Industries' perpetual preferred stock has a dividend yield of 11%. This means that for each share with a \( \\(100 \) par value, the company pays \( \\)11 \) annually as dividends.
This percentage is essential when evaluating an investment in preferred stocks.
  • How it Works: The yield can help investors gauge how much return they can expect from dividends if they purchase the stock at its par value.
  • Importance: By understanding the yield, investors can compare it with other investment opportunities and analyze if the risk and return align with their financial goals.
  • Formula: If you need to calculate it, use the formula \( \text{Annual Dividend} \ \div \text{Par Value} \).
The consistency of the dividend yield in preferred stocks makes them attractive to investors seeking a dependable income stream.
Flotation Costs
Flotation costs are the expenses incurred when a company issues new securities. For preferred stocks, these costs must be subtracted from the selling price to calculate the net price per share.
In the Trivoli Industries example, the flotation cost is 5% of the market price, which means an adjustment needs to be made when assessing the stock's actual earnings potential.
  • Why Flotation Costs Matter: They impact the fundraising amount the company actually receives.
  • Calculating Flotation Costs: If a stock sells at \( \\(97 \) but the flotation cost is 5%, the calculation would be \( \\)97 \times 0.05 = \\(4.85 \), leaving a net price of \( \\)92.15 \).
  • Impact on Investors: For investors, knowing these costs can help in understanding how much of the received proceeds are used for strategic growth, potentially affecting future dividends or the company's value.
Investors need to account for flotation costs to accurately assess the costs and benefits of an investment.
Perpetual Preferred Stock
Preferred stocks typically represent a hybrid between debt and equity. Perpetual preferred stocks, like the one issued by Trivoli Industries, do not have a maturity date. This means they continue to pay dividends indefinitely.
This stock feature offers both opportunities and challenges:
  • Pros: The indefinite term allows for steady dividends, beneficial for long-term income investors.
  • Cons: Since they do not mature, investors can't expect to reclaim their principal investment on a specific date, unlike bonds.
  • Comparison with Common Stock: Perpetual preferred stockholders receive dividends before common shareholders, which may also be at a higher yield.
Investors considering perpetual preferred stocks must be comfortable with the long-term commitment and the specific financial health of the issuing company.

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Most popular questions from this chapter

cost of preferred stock Tunney Industries can issue perpetual preferred stock at a price of \(\$ 47.50\) a share. The stock would pay a constant annual dividend of \(\$ 3.80\) a share. What is the company's cost of preferred stock, \(r_{p} ?\)

Ziege Systems is considering the following independent projects for the coming year. Ziege's WACC is 10 percent, but it adjusts for risk by adding 2 percent to the WACC for high-risk projects and subtracting 2 percent for low-risk projects. a. Which projects should Ziege accept if it faces no capital constraints? b. If Ziege can only invest a total of \(\$ 13\) million, which projects should it accept, and what would the dollar size of its capital budget be? c. Suppose that Ziege can raise additional funds beyond the \(\$ 13\) million, but each new increment (or partial increment) of \(\$ 5\) million of new capital will cause the WACC to increase by 1 percent. Assuming Ziege uses the same method of risk adjustment, which projects should it now accept, and what would be the dollar size of its capital budget?

Sidman Products' common stock currently sells for \(\$ 60\) a share. The firm is expected to earn \(\$ 5.40\) per share this year and to pay a year-end dividend of \(\$ 3.60,\) and it finances only with common equity. a. If investors require a 9 percent return, what is the expected growth rate? b. If Sidman reinvests retained earnings in projects whose average return is equal to the stock's expected rate of return, what will be next year's EPS? [Hint: \(\mathrm{g}=(1-\) Payout \(\text { rate } )(\mathrm{ROE}) .]\)

After-tax cost of debt The Heuser Company's currently outstanding bonds have a 10 percent coupon and a 12 percent yield to maturity. Heuser believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 35 percent, what is Heuser's after-tax cost of debt?

Ballack Co.'s common stock currently sells for \(\$ 46.75\) per share. The growth rate is a constant 12 percent, and the company has an expected dividend yield of 5 percent. The expected long-run dividend payout ratio is 25 percent, and the expected return on equity (ROE) is 16 percent. New stock can be sold to the public at the current price, but a flotation cost of 5 percent would be incurred. What would the cost of new equity be?
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