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Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change?

A)	Waterbury’s return on equity (ROE).

B)	Waterbury’s after-tax cost of corporate debt.

C)	Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock.

Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury’s after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury’s ROE will be affected by the change.

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?

A)	The stated par value of the preferred issue.

B)	The preferred stock’s dividend rate.

C)	The firm’s corporate tax rate.

The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.

The cost of preferred stock, kps is expressed as:
k_ps = D_ps / P

where:
D_ps = divided per share = dividend rate × stated par value
P = market price

Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is:

A)	the market price of the preferred shares as a percentage of its issuance price.

B)	approximately equal to the market price of the firm’s debt as a percentage of the market price of its common shares.

C)	the dividend yield on the firm’s newly-issued preferred stock.

The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm’s newly-issued preferred shares is the market’s required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.

A)	equal to the before-tax cost of preferred stock.

B)	less than the before-tax cost of preferred stock.

C)	higher than the cost of common shares.

The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.