PNC also raises capital with preferred stock. Data on preferred stock are also p
ID: 2717958 • Letter: P
Question
PNC also raises capital with preferred stock. Data on preferred stock are also provided in Table 1. If PNC finances with preferred, which type should it choose, and what would its cost be for the WACC calculation? Is the relationship between the yields on the two pre- ferreds, and between the preferreds and debt, consistent with their risks to investors? Would an increase in the percentage flotation cost have a greater impact on the sinking fund or per- petual preferred?
TABLE 1.Preferred Stock Data. PNC has one issue of preferred stock outstanding, a perpetual and non-callable preferred that pays a $6.25 annual dividend, has a $100 par value, and currently sells for $104 per share. Investment bankers have indicated that PNC could sell additional shares with a dividend rate that would provide the same market yield, but would incur a flotation cost of 2%. Also, it could sell at par an issue of sinking fund preferred with an annual coupon of 5.25%. The sinking fund would require the company to retire 10% of the original shares each year after issuance, and it too would have a 2 percent flotation cost.
Explanation / Answer
Annual Dividend on preferred stock = $ 6.25
Par Value = $ 100
Current Price = $ 104
Yield on preferred stock = X
Price of preferred stock = Annual Dividend / Yield on preferred stock
$ 104 = $ 6.25/x
X = $ 6.25/$104 = 0.0600961 or 6.01% (rounded off)
Yield of existing preferred stock = 6.01%
For New Preferred stock Issue
Dividend rate = $ 6.25 (same as existing one)
Yield = 6.01% (same as existing one)
Floatation cost = 2%
Price of the preferred stock = Annual Dividend / yield *(1-floatation cost)
Price of preferred stock = $ 6.25 / 0.0601 * (1-0.02)
Price = $ 6.25 /(0.0601*0.98)
Price = $ 6.25 /0.058898 = $ 106.1156 or $ 106.12 (rounded off)
Price at which new preferred stock can be issued is $ 106.12
Let X be the amount of sinking fund which is set up such that an amount equal to 10% is utilised for retiring 10% of the preferred stock. The floatation cost for setting up such a fund is 2%
Then the initial amount required is = X + 2%* X = 1.02 * X
Annual amount required to retire the shares = 10% of Par Value = 100 * 10% = $ 10
Period of sinking fund n = 1/10% = 10 years
Annual interest rate r = 5.25% or 0.0525
Annual amount required to retire the shares = Initial amount required/[((1+r)^10 -1) / r]
Substituting the above values
$ 10 = 1.02 * X /[((1+0.0525)^10 -1) / 0.0525]
$ 10 = 1.02* X / [(1.668096 – 1)/0.0525]
$ 10 = 1.02*X /(0.668096/0.0525)
$ 10 = 1.02*x /12.72563839
1.02*x = $ 10 * 12.72563839
X = ($ 10 * 12.72563839)/1.02 = 127.2563839/1.02
X = 124.76116 or 124.76 (rounded off)
The company should set up a sinking fund at 5.25% annual with an initial value of $ 124.76 for each preferred share of par value $ 100 to account for 2% floatation cost and retire 10% of the preferred stock every year.
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