Question

The treasurer of Kelly Bottling Company (a corporation) currently has $230,000 invested in preferred stock yielding 7 percent. He appreciates the tax advantages of preferred stock and is considering buying $230,000 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 2 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?

• No

• Yes

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?

• Favorable

• Unfavorable

Answer 1

(A) Income from the new purchase would be $230,000 * 7% = $16,100

Taxes would be 10% of this amount = 16,100*10% = 1,610

After tax income = (16,100 - 1,610) = $14,490

(B) Borrowinfg cost = 230,000 * 9% = $20,700

Tax saved on this interest (interest payments are tax deductible) = $20,700 * 30% = 6,210

Net cost = (20,700 - 6,210) = 14,490

(C) Given that the cost of borrwing is same as the dividend cost, the treasurer shall be indifferent between the two prposals. It will neither add nor destroy any value for the company.

(D) If the interest rate increase, and the dividend yield increase will reduce the PV of the future payments. (Higher discount rates) thus, it will make the project unfavourable. Since, the rates will increase post investing by company, it wll not impact the interest income or payment. However, if they redeem the loan in the market, they will have to pay less.

Favourable.