"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:

Corporate Finance:capital budget

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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