Acme Services’ CFO is considering whether to take on a new project that has aver

Question

Acme Services’ CFO is considering whether to take on a new project that has average risk. She has collected the following information: • The company has outstanding bonds that mature in 26 years. The bonds have a face value of $1,000, an annual coupon of 7.5%, and sell in the market today for $920. There are 10,000 bonds outstanding. • The risk-free rate is 6%. • The market risk premium is 5%. • The stock’s beta is 1.2. • The company’s tax rate is 40%. • The company has 50,000 shares of preferred stock with a par value of $100. These shares are currently trading at $105, and pay an annual dividend of $5.40. • The company also has 1,850,000 common shares trading at $25. These shares last paid an annual dividend of $0.93. What is Acme’s cost of preferred equity?

Explanation / Answer

Acme’s cost of preferred equity =

AS per CAPM

Ke = risk free return + beta * market risk premium

= 6% + 1.2* 5%

= 12%

AS per gordon model

Ke= d1/p0

= .93 / 25 = 3.72%

cost of Preffered stock = annual dividend/net offering price

= 5.4 /105 = 5.14%

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