Chartered Financial Analyst Level 2

Explanation

The cost of preferred equity is calculated using the formula:

$r_p = \frac{D_p}{P_p}$

Where:

• $r_p$ = cost of preferred equity
• $D_p$ = annual preferred dividend
• $P_p$ = current market price per share

Step 1: Calculate the annual dividend D_p = \text{Par value} \times \text{Dividend rate} = \`$150` \times 8.0\% = \`$150` \times 0.08 = \`$12`

Step 2: Calculate the cost of preferred equity r_p = \frac{\`$12`}{\`$140`} = 0.0857 \text{ or } 8.57\%

Step 3: Compare with options

• 8.57% is closest to 8.6% (Option C)

Key Points:

• The dividend is based on the par value ($150), not the market price
• The cost is calculated using the current market price ($140)
• When preferred stock trades above par value, the cost is lower than the dividend rate
• When preferred stock trades below par value, the cost is higher than the dividend rate

In this case, since the stock trades below par ($140 < $150), the cost (8.57%) is higher than the dividend rate (8.0%).