CDE Inc.\'s current (and optimal) capital structure is 40% debt, 10% preferred s

Question

CDE Inc.'s current (and optimal) capital structure is 40% debt, 10% preferred stock, and 50% common equity. CDE is in the 40% tax bracket. The company can issue up to $20,000,000 in new bonds at par with a 7% coupon rate; any subsequent amount must carry a 2% premium to compensate investors for added risk. A new issue of preferred stock would pay an annual dividend of $4.00 and be priced to net the company $50.00 per share after the $3.00 per share floatation cost. The firm has $21,000,000 in change in retained earnings for the current period. CDE's common stock trades at $40.00 per share and the expected dividend on the common stock at t1 is 2.00. Floatation costs on a new common stock issue is $5.00 per share. The company is growing at 7% per year. Reference:

Ref 9-2

What is the cost of preferred stock?

8.0%

8.5%

20.0%

12.5%

Explanation / Answer

Cost of preferred stock = annual dividend / (Share price - Flotation cost)

Cost of preferred stock = 4/(50-3)

Cost of preferred stock = 8.5%

Answer

8.5%

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