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The total investment required for a new chemical plant is estimated at $20 million. Fifty percent...

The total investment required for a new chemical plant is estimated at $20 million. Fifty percent will be supplied from the company's noncapital resources. Of the remaining investment one-half will come from a loan at an effective interest rate of 8 percent and one -half will come from an issue of preferred stock paying dividends at a stated effective rate of 8 percent. The income tax rate for the company is 35 percent of pretax earnings. Under these conditions. How many dollars per year does the company lose (i.e. after taxes) by issuing preferred stock at 8 percent dividend instead of bonds at an effective interest rate of 6 percent?

Expert Solution

total investment required = $20 million

Amount raised from non capital resources

= 0.50 * $20 million

= $10 million

Remaining investment required = $20 million - $10 million

= $10 million

Loan taken =0.50 * $10 million = $5 million

For 1 year , interest paid = $5 million x 0.08 = $0.4 million

Remaining investment required = $10 million - $5 million

= $5 million

Raised from stock paying dividends at dividend paying rate of 8%

Dividend for a year = $5 million x 0.08 = $0.4 million

Income of the company = $5 million + $0.4 million

= $5.4 million

Taxes paid = $5.4 million * 0.35 = $1.89 million

Income after taxes = $5.4 million - $1.89 million

= $3.51 million

If company raise the $5 million investment from the bonds at 6% rate Then,

Interest for a year = $5 million x 0.06 = $0.3 million

Income of the company = $5 million + $0.3 million

= $5.3 million

Taxes paid = $5.3 million * 0.35 = $1.855 million

Income after taxes = $5.3 million - $1.855 million

= $3.445 million

Company lose per year = $3.51 million - $3.445 million

= $0.065 million

= $65,000

Amanda K answered 2 years ago

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