Corporate financeLesson 5 of 5 in the course How Firms Raise Capital

Preferred Shares, Common Equity, and Convertible Bonds

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

This lesson explains how preferred shares fit into a firm’s financing and how to calculate their required return. It also shows how preferred equity is incorporated into the weighted average cost of capital (WACC).

WACC=wdrd(1−T)+wpfdrpfd+were\text{WACC} = w_d r_d(1-T) + w_{pfd}r_{pfd} + w_e r_e

Here, wdw_d, wpfdw_{pfd}, and wew_e are the proportions of debt, preferred equity, and common equity in the firm’s financing; rdr_d, rpfdr_{pfd}, and rer_e are their respective costs; and TT is the corporate tax rate. The interest tax adjustment applies to debt in this formula. Preferred dividends are not treated as tax-deductible interest.

All flashcards

How is preferred equity treated in WACC?
As a separate financing source, weighted by its share of financing and multiplied by its required return; the debt tax adjustment does not apply to preferred dividends.
Why do retained earnings have a cost to shareholders?
Shareholders give up the opportunity to invest those funds elsewhere and expect a return on capital left in the firm.
How are flotation costs reflected in the cost of newly issued equity?
They reduce net proceeds per share: re−new=D1P0−F+gr_{e-new}=\frac{D_1}{P_0-F}+g.
How is a convertible bond’s conversion price calculated?
Divide the bond’s face value by its conversion ratio.
Why does a conversion option have value to a bondholder?
It lets the holder choose between cash repayment and shares, depending on which is more valuable.

Quiz questions

  1. Preferred shares pay an annual dividend of $2.40 and sell for $30 per share. What is their cost?Answer: 8%.
  2. A firm targets 30% debt and 70% equity and raises $2 million. How much debt is consistent with its target?Answer: $600,000.
  3. A company expects a dividend of $0.60 next year, has a share price of $10, and expects constant growth of 4%. Using the constant-growth dividend model, what is its cost of common equity?Answer: 10%.
  4. A $1,000 bond has a conversion ratio of 25 shares. What is its conversion price per share?Answer: $40.
  5. Why does a lower coupon on convertible debt not, by itself, prove that the debt lowers a firm’s overall financing cost?Answer: Bondholders may receive shares worth more than the bond’s face value upon conversion.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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