Question

The treasurer of Kelly Bottling Company (a corporation) currently has $350,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $350,000 more with borrowed funds. The cost of the borrowed funds is 9 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 1 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 30 percent tax bracket, with dividends taxed at 10 percent.

a. Compute the amount of the aftertax income from the additional preferred stock if it is purchased. (Do not round intermediate calculations and round your answer to the nearest whole dollar.)

b. Compute the aftertax borrowing cost to purchase the additional preferred stock. (Do not round intermediate calculations and round your answer to the nearest whole dollar.)

The treasurer of Kelly Bottling Company (a corporation) currently has $350,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $350,000 more with borrowed funds. The cost of the borrowed funds is 9 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 1 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 30 percent tax bracket, with dividends taxed at 10 percent.

a. Compute the amount of the aftertax income from the additional preferred stock if it is purchased. (Do not round intermediate calculations and round your answer to the nearest whole dollar.)

b. Compute the aftertax borrowing cost to purchase the additional preferred stock. (Do not round intermediate calculations and round your answer to the nearest whole dollar.)

c. Should the treasurer proceed with his proposal?

d.. If market interest rates and dividend yields increase six months after a purchase decision is made, will the impact of those increases be favorable or unfavorable for the firm?

Answer 1

Step 1

a.

The preferred stock has an 8% yield. The current yield on preferred stock will be $28,000

Dividend amount = $350000 × 8% = $ 28000

In Preferred stock, the tax exemption is given on seventy percent of the dividend which means 70% of the dividend is not taxable and rest 30% of the dividend is taxable.

Taxable dividend yield = 30%($28000) = $8400

Dividend tax rate is 20%.

Taxes on dividend = 10%($8400) = $840

After tax returns = dividend yield - tax on dividend = $28000- 840 = $ 27160

The after-tax return on preferred stock is $27160

Step 2

b.

Borrowing fund: The after-tax return is calculated as:

After tax cost = interest cost (1- tax rate).

The cost of borrowing fund is 9% and the corporate tax rate is 30%. The amount of interest will be 9% of $350,000.

Interest = $350000×9% = $31500

Substitute:

After tax cost = $31500 ( 1-30%) = $22050

The after-tax return on borrowing funds is $22050.

Step 3

c.

No, the treasurer should not proceed with the proposal as the after tax cost of borrowing is more than the after-tax income.

Step 4

d.

There will have a negative impact on the outcome. The increased yield on dividend will reduce the total value of portfolio by the amount of $350,000. Apart from this, the nature of interest rates is fluctuating and not fixed which can result in the increased cost of borrowings.

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