Corporate Finance Quiz: Cost Of Preferred Stock
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Cost Of Preferred StockQuestion 1 of 20

A firm is analyzing its cost of capital. Its perpetual preferred stock pays a fixed annual dividend of $5 per share and currently trades at $62.50. The firm's common stock dividends are expected to grow at a constant rate of 4% per year. What is the firm's component cost of preferred stock?

4.00%
8.00%
12.00%
12.50%
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Corporate Finance Quiz

Corporate Finance Quiz: Cost Of Preferred Stock

Practice Cost Of Preferred Stock in Corporate Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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This quiz focuses on Cost Of Preferred Stock, giving you a quick way to practice the rules, question types, and explanations that matter most for Corporate Finance.

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Question 1

A firm is analyzing its cost of capital. Its perpetual preferred stock pays a fixed annual dividend of $5 per share and currently trades at $62.50. The firm's common stock dividends are expected to grow at a constant rate of 4% per year. What is the firm's component cost of preferred stock?

  1. 4.00%
  2. 8.00% (correct answer)
  3. 12.00%
  4. 12.50%
Explanation: The cost of preferred stock is calculated using the perpetuity model, as its dividends are fixed and do not grow. The growth rate associated with common stock is irrelevant information intended to be a distractor.
r_p = D_p / P_p = \5.00 / $62.50 = 0.08$ or 8.00%.

Question 2

A company can issue preferred stock with a par value of $100 and a 7.5% dividend for $102 per share, incurring flotation costs of 4%. Alternatively, it can issue bonds at par with a 6.5% coupon. The company's marginal tax rate is 25%. What is the difference between the cost of preferred stock and the after-tax cost of debt?

  1. 1.00%
  2. 2.48%
  3. 2.79% (correct answer)
  4. 3.17%
Explanation: This requires calculating and comparing the costs of two different financing sources.\
  1. Cost of Preferred Stock (rpr_p):\
    • Dividend: D_p = \100 \times 0.075 = $7.50$\
    • Net Proceeds: P_{net} = \102 \times (1 - 0.04) = $97.92$\
    • r_p = \7.50 / $97.92 \approx 7.66%$\
  2. After-Tax Cost of Debt (rd(1−T)r_d(1-T)):\
    • Pre-tax cost of debt: rd=6.5%r_d = 6.5\% (since issued at par)\
    • After-tax cost: 6.5%×(1−0.25)=6.5%×0.75=4.875%6.5\% \times (1 - 0.25) = 6.5\% \times 0.75 = 4.875\%\
  3. Difference: (7.66% - 4.875% = 2.785% ≈\approx 2.79%).

Question 3

If prevailing market interest rates rise, what is the most likely impact on a company's marginal cost of preferred stock, assuming the dividend payments are fixed?

  1. It will increase, because the market price of the preferred stock will fall. (correct answer)
  2. It will decrease, because the fixed dividend becomes more attractive to investors.
  3. It will remain unchanged, because the dividend is contractually fixed.
  4. It will increase, because the company will be forced to increase its dividend payout.
Explanation: The cost of preferred stock (rp=Dp/Ppr_p = D_p / P_p) is the yield required by investors. If overall market interest rates rise, investors will demand a higher yield on all fixed-income investments, including preferred stock. Since the dividend (DpD_p) is fixed, the market price (PpP_p) must fall to provide a higher yield. A lower price for the same dividend results in a higher cost of capital for the firm.

Question 4

A company is issuing preferred stock that pays an annual dividend of $10. The company's financial advisor states that, after accounting for issuance costs, the effective cost of this capital will be 9.20%. If the stock is sold to the public for $115 per share, what are the flotation costs as a percentage of the selling price?

  1. 5.96%
  2. 6.35% (correct answer)
  3. 8.70%
  4. 9.20%
Explanation: This is a multi-step problem where you solve for the flotation cost percentage.\
  1. Calculate the net proceeds (PnetP_{net}) the company must have received for the cost to be 9.20%: P_{net} = D_p / r_p = \10.00 / 0.092 = $108.6957$\
  2. Calculate the dollar flotation cost per share: FC_\ = \text{Selling Price} - P_{net} = $115.00 - $108.6957 = $6.3043$\
  3. Calculate the flotation cost as a percentage of the selling price: F = FC_\ / \text{Selling Price} = $6.3043 / $115.00 \approx 0.0635$ or 6.35%.

Question 5

A firm is evaluating its cost of capital. An analyst determines that the market's required rate of return on the firm's preferred stock is 7.5%. The stock pays an annual dividend of $6.00 and has a par value of $100. Flotation costs for a new issue would be 5% of the proceeds. What is the estimated cost of a new issue of preferred stock?

  1. 7.50%
  2. 7.89% (correct answer)
  3. 8.00%
  4. 8.42%
Explanation: This question requires calculating the cost to the company, which must account for flotation costs.\
  1. First, find the market price (PpP_p) that provides investors with their required 7.5% return: P_p = D_p / r_p = \6.00 / 0.075 = $80.00$\
  2. Next, calculate the net proceeds to the company after flotation costs: P_{net} = \80.00 \times (1 - 0.05) = $76.00$\
  3. Finally, calculate the cost of the new issue to the company based on these net proceeds: \text{Cost} = D_p / P_{net} = \6.00 / $76.00 \approx 0.0789$ or 7.89%.

Question 6

A company is planning a new issue of preferred stock. Investors require an 8.0% return on this type of security. The stock will pay a $6.00 annual dividend. Flotation costs are expected to be 4.0% of the gross proceeds. At what price must each share be sold to the public to ensure it is fully subscribed?

  1. $72.00
  2. $75.00 (correct answer)
  3. $78.00
  4. $78.13
Explanation: The price the public pays is determined by the dividend and the return they require. Flotation costs affect the net proceeds to the company but not the price investors pay.
The market price (PpP_p) is the present value of the perpetual dividend stream discounted at the investors' required rate of return.
P_p = D_p / r_p = \6.00 / 0.08 = $75.00. Thecompanywillreceive.\ The company will receive $75.00 \times (1 - 0.04) = $72.00$ after flotation costs.

Question 7

A firm's preferred stock pays a $9 annual dividend and trades at $112.50 per share. The stock is callable in 3 years at 105% of its $100 par value. For the purpose of calculating the firm's WACC, what is the cost of its preferred stock?

  1. 7.62%
  2. 8.00% (correct answer)
  3. 8.40%
  4. 8.57%
Explanation: The cost of perpetual preferred stock is calculated as its annual dividend divided by its current market price. The call feature is generally ignored for this calculation unless the question specifically asks for a yield-to-call or if the stock is likely to be called. The standard approach for WACC uses the perpetuity model.
r_p = D_p / P_p = \9.00 / $112.50 = 0.08$ or 8.00%. The information about the call feature and par value is extraneous for this specific question.

Question 8

Stellar Corp. plans to issue new perpetual preferred stock to finance a project. The stock will have a par value of $100, pay an annual dividend of $7.00, and is expected to sell for $104 per share. Flotation costs are anticipated to be 5% of the market price. What is the estimated cost of this preferred stock for Stellar?

  1. 6.73%
  2. 7.00%
  3. 7.09% (correct answer)
  4. 7.37%
Explanation: The cost of preferred stock (rpr_p) is the annual dividend (DpD_p) divided by the net proceeds from the sale of the stock (PnetP_{net}). The net proceeds are the market price minus flotation costs.\
  1. Calculate the flotation cost per share: FC = \104.00 \times 0.05 = $5.20$\
  2. Calculate the net proceeds per share: P_{net} = \104.00 - $5.20 = $98.80$\
  3. Calculate the cost of preferred stock: r_p = D_p / P_{net} = \7.00 / $98.80 \approx 0.07085$ or 7.09%.

Question 9

A company has two series of preferred stock outstanding. Series A has a dividend of $7 and a market price of $87.50. Series B has a dividend of $9 and a market price of $112.50. Both series are considered to be of equal risk. What is the company's estimated cost of preferred stock for capital budgeting purposes?

  1. 8.00% (correct answer)
  2. 8.50%
  3. 9.14%
  4. 10.00%
Explanation: To find the company's cost of preferred stock, calculate the current yield on each series. Since they are of equal risk, their costs should be identical or very similar, reflecting the current market requirement.
Cost of Series A: r_{p,A} = \7.00 / $87.50 = 0.08 = 8.00% CostofSeriesB:\ Cost of Series B: r_{p,B} = $9.00 / $112.50 = 0.08 = 8.00%$
Both series indicate a current market cost of 8.00%.

Question 10

A company's preferred stock pays a quarterly dividend of $1.50 per share and currently trades at $85.00 per share. If the company were to issue new preferred shares, it would incur flotation costs of 6.0%. What is the component cost of the new preferred stock issue?

  1. 1.76%
  2. 1.87%
  3. 7.06%
  4. 7.51% (correct answer)
Explanation: The calculation requires annualizing the dividend and accounting for flotation costs.\
  1. Calculate the annual dividend: D_p = \1.50/\text{quarter} \times 4 \text{ quarters} = $6.00$\
  2. Calculate the net proceeds per share: P_{net} = \text{Market Price} \times (1 - \text{Flotation Cost \%}) = \85.00 \times (1 - 0.06) = $85.00 \times 0.94 = $79.90$\
  3. Calculate the cost of preferred stock: r_p = D_p / P_{net} = \6.00 / $79.90 \approx 0.07509$ or 7.51%.

Question 11

A firm's newly issued preferred stock has a required rate of return of 8.5%. The stock pays an annual dividend of $7.50 and was issued at a price of $94.00 per share. What were the flotation costs as a percentage of the issue price?

  1. 5.53% (correct answer)
  2. 5.84%
  3. 7.98%
  4. 8.50%
Explanation: This problem requires working backward from the cost to find the flotation cost percentage.\
  1. Calculate the net proceeds (PnetP_{net}) implied by the cost: P_{net} = D_p / r_p = \7.50 / 0.085 = $88.235$\
  2. Calculate the total dollar flotation cost: FC_\ = \text{Issue Price} - P_{net} = $94.00 - $88.235 = $5.765$\
  3. Calculate flotation cost as a percentage of the issue price: F = FC_\ / \text{Issue Price} = $5.765 / $94.00 \approx 0.0553$ or 5.53%.

Question 12

A utility company, known for its stable cash flows, has preferred stock outstanding that pays a $5.00 annual dividend. The stock currently trades at $70.00 per share. If the company issues new preferred stock, flotation costs will be $4.00 per share. What is the cost of the new preferred stock issue?

  1. 6.62%
  2. 7.14%
  3. 7.58% (correct answer)
  4. 8.21%
Explanation: The cost of a new issue of preferred stock must be based on the net proceeds the company receives.\
  1. The market price of the new issue will be the same as the current market price: $70.00.\
  2. Calculate the net proceeds per share after flotation costs: P_{net} = \text{Market Price} - \text{Flotation Cost} = \70.00 - $4.00 = $66.00$\
  3. Calculate the cost of the new issue using the net proceeds: r_p = D_p / P_{net} = \5.00 / $66.00 \approx 0.07575$ or 7.58%.

Question 13

An analyst is calculating a firm's WACC. The firm's capital structure includes preferred stock with a market value of $20 million. The total annual preferred dividends are $1.7 million. The firm's marginal tax rate is 21%. What is the component cost of preferred stock?

  1. 6.72%
  2. 8.08%
  3. 8.50% (correct answer)
  4. 10.76%
Explanation: The cost of preferred stock can be calculated using aggregate market values and dividend payments. It is the total annual preferred dividend divided by the total market value of preferred stock. The tax rate is not used because preferred dividends are not tax-deductible.
r_p = \text{Total Annual Dividends} / \text{Total Market Value} = \1,700,000 / $20,000,000 = 0.085$ or 8.50%.

Question 14

A company's perpetual preferred stock was issued several years ago with a $100 par value and a 6% dividend. Due to a decrease in the company's risk profile, its current cost of preferred stock is 5%. What is the current market price per share of this preferred stock?

  1. $83.33
  2. $100.00
  3. $120.00 (correct answer)
  4. $125.00
Explanation: To solve for the current market price, rearrange the cost of preferred stock formula (rp=Dp/Ppr_p = D_p / P_p) to Pp=Dp/rpP_p = D_p / r_p.\
  1. Calculate the annual dollar dividend, which is fixed from the time of issue: D_p = \text{Par Value} \times \text{Original Dividend Rate} = \100 \times 0.06 = $6.00$\
  2. Use the current cost of preferred stock (the market's required return) to find the current market price: P_p = \6.00 / 0.05 = $120.00$.

Question 15

Apex Industries has preferred stock outstanding with a 6% dividend rate on a $100 par value. The stock is currently trading at $75 per share. The company's marginal tax rate is 25%. For purposes of calculating the firm's weighted average cost of capital (WACC), what is the component cost of this preferred stock?

  1. 4.50%
  2. 6.00%
  3. 8.00% (correct answer)
  4. 10.67%
Explanation: First, calculate the annual dollar dividend. Then, divide by the current market price. The tax rate is irrelevant because preferred dividends are not tax-deductible for the issuing firm.\
  1. Calculate the annual dividend: D_p = \text{Par Value} \times \text{Dividend Rate} = \100 \times 0.06 = $6.00$\
  2. Calculate the cost of preferred stock: r_p = D_p / P_p = \6.00 / $75.00 = 0.08$ or 8.00%.

Question 16

A company issues perpetual preferred stock with a par value of $50 and a 9% dividend rate, payable annually. The stock is issued at $48 per share, with flotation costs of $2.50 per share. What is the estimated cost of this preferred stock?

  1. 9.00%
  2. 9.38%
  3. 9.89% (correct answer)
  4. 10.34%
Explanation: This calculation involves finding the dollar dividend, calculating the net proceeds, and then finding the cost.\
  1. Calculate the annual dividend: D_p = \text{Par Value} \times \text{Dividend Rate} = \50.00 \times 0.09 = $4.50$\
  2. Calculate the net proceeds: P_{net} = \text{Issue Price} - \text{Flotation Cost} = \48.00 - $2.50 = $45.50$\
  3. Calculate the cost of preferred stock: r_p = D_p / P_{net} = \4.50 / $45.50 \approx 0.0989$ or 9.89%.

Question 17

Meridian Industries issued preferred stock five years ago with a $100 par value and $6.5%6.5\% annualdividendrate.Thestockiscallableat$105andcurrentlytradesat$98.Interestrateshavedeclinedsinceissuance,andsimilarriskpreferredstocksnowyield$ annual dividend rate. The stock is callable at $105 and currently trades at $98. Interest rates have declined since issuance, and similar risk preferred stocks now yield $5.8%$$. For cost of capital calculations, what rate should Meridian use for its existing preferred stock?

  1. 5.80%5.80\% reflecting current market yields for similar risk securities
  2. 6.50%6.50\% based on the original dividend rate specified at issuance
  3. 6.63%6.63\% calculated using current market price and existing dividends (correct answer)
  4. 6.19%6.19\% using the call price as the relevant market value
Explanation: For existing preferred stock in cost of capital calculations, use the current market-based cost: annual dividend divided by current market price. Annual dividend = $100×0.065=$6.50\$100 \times 0.065 = \$6.50. Cost = $6.50/$98=6.63%\$6.50 / \$98 = 6.63\%. Choice A uses market yields but ignores the company's specific dividend rate. Choice B uses the historical rate without considering current market conditions. Choice D incorrectly uses the call price instead of market price.

Question 18

Omega Technologies issued preferred stock with an adjustable rate tied to LIBOR plus 200200 basis points, subject to a 3.0%3.0\% floor and 9.0%9.0\% ceiling. The $80 par value shares trade at $76.50. Current LIBOR is $2.8%2.8\% ,butmarketanalystsexpectLIBORtoaverage, but market analysts expect LIBOR to average 3.5%3.5\% $ over the next year. For cost of capital purposes, what rate should be used?

  1. 6.27%6.27\% using current LIBOR rate and current market pricing (correct answer)
  2. 7.19%7.19\% using expected average LIBOR rate and current market pricing
  3. 4.80%4.80\% applying current LIBOR plus spread to par value
  4. 5.50%5.50\% using expected LIBOR plus spread applied to par value
Explanation: For cost of capital calculations, use current conditions. Current dividend rate = LIBOR + 200bp = 2.8%+2.0%=4.8%2.8\% + 2.0\% = 4.8\% (above 3.0%3.0\% floor, below 9.0%9.0\% ceiling). Annual dividend = $80×0.048=$3.84\$80 \times 0.048 = \$3.84. Cost = $3.84/$76.50=6.27%\$3.84 / \$76.50 = 6.27\%. Choice B uses forecasted rates inappropriately for current cost calculations. Choice C applies cost to par instead of market value. Choice D uses both forecasted rates and par value incorrectly.

Question 19

TechFlow Corp.'s preferred stock pays a quarterly dividend of $0.85 per share and trades at $42 per share. The company is considering issuing additional preferred stock and expects flotation costs of $3.5%3.5\% .However,duetorecentcreditratingconcerns,newpreferredstockwouldneedtooffera. However, due to recent credit rating concerns, new preferred stock would need to offer a 0.4%0.4\% $ higher yield than existing stock to attract investors. What should TechFlow use as the cost of new preferred stock?

  1. 8.48%8.48\% using existing dividend rate plus yield premium on current market price
  2. 8.88%8.88\% incorporating both flotation costs and the required yield premium (correct answer)
  3. 8.41%8.41\% applying flotation costs to existing dividend and market price relationship
  4. 8.10%8.10\% adding yield premium to existing cost without flotation adjustments
Explanation: This requires multiple adjustments: First, calculate existing cost: $0.85×4=$3.40\$0.85 \times 4 = \$3.40 annual dividend; $3.40/$42=8.10%\$3.40 / \$42 = 8.10\%. New stock needs 8.10%+0.4%=8.50%8.10\% + 0.4\% = 8.50\% yield. With 3.5%3.5\% flotation costs, net proceeds = $42×0.965=$40.53\$42 \times 0.965 = \$40.53. Required dividend = $40.53×0.085=$3.45\$40.53 \times 0.085 = \$3.45. Cost = $3.45/$40.53=8.88%\$3.45 / \$40.53 = 8.88\%. Choice A ignores flotation costs. Choice C ignores the yield premium. Choice D ignores flotation costs.

Question 20

Global Manufacturing has preferred stock with a $25 par value and $5.6%5.6\% dividendrate,currentlytradingat$23.75.Thepreferredstockhasamandatoryconversionfeaturethatwillconverteachshareto$ dividend rate, currently trading at $23.75. The preferred stock has a mandatory conversion feature that will convert each share to $1.25$$ common shares in three years. Common stock currently trades at $17.50 per share. For immediate cost of capital purposes, how should this preferred stock be treated?

  1. Use 5.90%5.90\% based on current preferred dividend and market price relationship (correct answer)
  2. Use expected common stock dividend yield since conversion is mandatory
  3. Use 6.67%6.67\% reflecting the conversion value compared to current preferred price
  4. Use weighted average of preferred cost and common equity cost over three years
Explanation: For immediate cost of capital calculations, treat convertible preferred stock as preferred stock using current dividend and market price. Annual dividend = $25×0.056=$1.40\$25 \times 0.056 = \$1.40. Cost = $1.40/$23.75=5.90%\$1.40 / \$23.75 = 5.90\%. The mandatory conversion affects future capital structure but not current cost calculations. Choice B prematurely treats it as common equity. Choice C confuses conversion value with cost calculation. Choice D unnecessarily complicates the current period cost calculation.