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"Corporate Finance":capital budget
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Questions 1:
A class of noncallable, nonconvertible preferred stock was issued at $45.00 per share with a dividend of $5.25. The preferred stock is now trading at $60.00 per share. Earnings of the company are growing at 3.00%. The cost of preferred stock is closest to:
A 、11.7%.
B、 8.8%.
C、 5.8%.
Questions 2:
Which of the following statements is the most appropriate treatment of flotation costs for capital budgeting purposes? Flotation costs should be:
A、 expensed in the current period.
B、 incorporated into the estimated cost of capital.
C、 deducted as one of the project’s initial-period cash flows.
View answer resolution
【Answer to question 1】B
【analysis】
B is correct. The cost of preferred stock is:
The cost of preferred stock is 5.25/60.00 = 8.75%
C is incorrect. If the dividend growth rate of 3% is subtracted from 8.75% (as per the Gordon growth model), the conclusion will be 5.75%.
A is incorrect. If the issuance cost is being used instead of current price, it will lead to a wrong conclusion of 11.67%.
【Answer to question 2】C
【analysis】
C is correct. Flotation costs are an additional cost of the project and should be incorporated as an adjustment to the initial-period cash flows in the valuation computation.
A is incorrect. Expensing is an accounting treatment of the costs, not a capital budgeting treatment.
B is incorrect. Including the flotation cost in the estimated cost of capital is theoretically incorrect. By doing so we are adjusting the present value of the future cash flows by a fixed percentage, i.e., the adjusted cost of capital.
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