Share
Explore BrainMass

Preferred Stock, WACC, and Cost of Debt

1) Even though preferred stock is generally more risky to investors, the before-tax yield on preferred stock is sometimes less than the before-tax yield on the same company's bonds. Why?

2) A company has a capital structure that consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct?

A) The cost of equity financing is greater than or equal to the cost of debt financing. (correct answer)
b. The WACC exceeds the cost of equity financing.
c. The WACC is calculated on a before-tax basis.
d. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the marginal cost of capital.
e. The cost of retained earnings exceeds the cost of issuing new common stock.

3) Suppose a firm is losing money and thus, is not paying taxes, and that this situation is expected to persist for a few years whether or not the firm uses debt financing. Then the firm's after-tax cost of debt will equal its before-tax cost of debt. Why?

Solution Preview

1) Even though preferred stock is generally more risky to investors, the before-tax yield on preferred stock is sometimes less than the before-tax yield on the same company's bonds. Why?

Corporations own most of the preferred stock, because 70% of preferred dividends are nontaxable to corporations. (Interest income is taxable) Therefore, preferred often has a lower Before -Tax yield than debt. The After Tax yield to an investor, and the After Tax cost to the issuer (interest income is tax deductible, Preferred dividends are not tax deductible for investor), are higher on preferred than on debt reflecting the higher risk on the preferred ...

Solution Summary

Answers to questions on Preferred stock, WACC, Cost of debt.

$2.19