Cost Of Preferred Stock

Cost Of Preferred Stock112

Question .12 points QUESTION . 10-2 cost of preferred stock 1.12 points QUESTION . 10-3 what is cost of common equity 1.12 points QUESTION . 10-4 part a what is the cost of common equity without flotation cost 1.12 points QUESTION . 10-4 part b what is cost of equity with flotation cost 1.12 points QUESTION . 10-6 part a what is cost of common equity with DCF 1.12 points QUESTION . 10-6 part b what is cost of common equity with CAPM? 1.12 points QUESTION . 10-8 part a what is cost common equity 1.12 points QUESTION . 10-8 part b what is WACC image1.png image2.png image3.png image4.wmf

Paper For Above instruction

The evaluation of the cost of different types of capital such as preferred stock, common equity, and the weighted average cost of capital (WACC) is fundamental in corporate financial management. These costs influence investment decisions, capital structuring, and overall financial strategy. This paper discusses the methods to calculate the cost of preferred stock, the cost of common equity (with and without flotation costs), and methodologies like Discounted Cash Flow (DCF) and Capital Asset Pricing Model (CAPM). It also examines the calculation of WACC, an essential metric that incorporates the costs of debt and equity, adjusting for their proportions in the company's capital structure.

Starting with the cost of preferred stock, it is generally calculated as the dividend per share divided by the net issuing price. Preferred stock typically has a fixed dividend rate, and its cost reflects the return required by investors. The formula is often expressed as:

Cost of Preferred Stock = D / P0

where D is the dividend per preferred share, and P0 is the net issuing price. This rate does not account for flotation costs unless explicitly included.

When calculating the cost of common equity, two primary methods are regularly employed: the Dividend Discount Model (DDM) or Gordon Growth Model, and the Capital Asset Pricing Model (CAPM). The DDM estimates the cost based on dividend growth expectations:

Cost of Equity (DDM) = (D1 / P0) + g

where D1 is the next year's dividend, P0 is the current stock price, and g is the growth rate of dividends. This method is straightforward when dividends are expected to grow at a constant rate.

Alternatively, the CAPM calculates the cost of equity based on systematic risk:

Cost of Equity (CAPM) = Rf + β (Rm - Rf)

where Rf is the risk-free rate, β is the stock's beta, and Rm is the expected market return. This approach considers the risk premium demanded by investors for bearing market volatility.

Flotation costs, which include the expenses incurred during the issuance of new equity or preferred stock, impact the calculations. The cost with flotation costs adjusts the required rate upward to compensate for these expenses:

Cost of Equity (with Flotation) = (D1 / (P0 - F)) + g

where F represents the flotation costs per share.

The Discounted Cash Flow (DCF) method estimates the cost of equity by equating the present value of expected future dividends plus the stock's expected selling price to its current market price, solving for the required rate that makes this equality true.

The Weighted Average Cost of Capital (WACC) synthesizes the costs of debt, preferred stock, and equity, weighted by their shares in the overall capital structure:

WACC = (E/V) Re + (D/V) Rd (1 - T) + (P/V) Rps

where E, D, and P are the market values of equity, debt, and preferred stock respectively, V is the total value, Re is the cost of equity, Rd is the cost of debt, Rps is the cost of preferred stock, and T is the corporate tax rate.

Understanding and accurately calculating these components are crucial for financial managers to optimize capital structure, minimize cost of capital, and maximize firm value.

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