fm10 15 - Note, though, that the after-tax yield to a...

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c. 1. What is the firm's cost of preferred stock? Answer: Since the preferred issue is perpetual, its cost is estimated as follows: r ps = ) F 1 ( P D ps ps = ) 05 . 0 . 1 ( 95 . 116 $ ) 100 ($ 1 . 0 = 10 . 111 $ 10 $ = 0.090 = 9.0%. Note (1) that flotation costs for preferred are significant, so they are included here, (2) that since preferred dividends are not deductible to the issuer, there is no need for a tax adjustment, and (3) that we could have estimated the effective annual cost of the preferred, but as in the case of debt, the nominal cost is generally used. c. 2. Harry Davis’ preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: think about taxes.) Answer: Corporate investors own most preferred stock, because 70 percent of preferred dividends received by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield than the before-tax yield on debt issued by the same company.
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Unformatted text preview: Note, though, that the after-tax yield to a corporate investor, and the after-tax cost to the issuer, are higher on preferred stock than on debt. d. 1. What are the two primary ways companies raise common equity? Answer: A firm can raise common equity in two ways: (1) by retaining earnings and (2) by issuing new common stock. d. 2. Why is there a cost associated with reinvested earnings? Answer: Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business. If part of the earnings is retained, an opportunity cost is incurred: stockholders could have received those earnings as dividends and then invested that money in stocks, bonds, real estate, and so on. d. 3. Harry Davis doesnt plan to issue new shares of common stock. Using the CAPM approach, what is Harry Davis estimated cost of equity? Answer: r s = 0.07 + (0.06)1.2 = 14.2%. Mini Case: 10 - 15...
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