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%).