Question

The treasurer of Kelly Bottling Company (a corporation) currently has $180,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $180,000 more with borrowed funds. The cost of the borrowed funds is 10 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 34 percent tax bracket, with dividends taxed at 15 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.)
  

After Tax Income:

Please show work so I can understand. Thank you.

Answer 1

Total amount borrowed for additional preferred stock =180000

Dividend earned from additional preferred stock= Return yield * 180000 = 8%* 180000 = 14400

After tax income from additional preferred stock= Dividend earned * (1-Tax on dividend) = 14400*(1-0.15) = 12240

Tax saved from additional borrowing = Tax rate * (Interest paid on additional borrowing) = 0.34 * (10%*180000) = 0.34* 18000=6120

Interest paid on additional borrowing= 10%* 180000=18000

Net earnings from additional borrowing= After tax income from additional preferred stock+Tax saved from additional borrowing- Interest paid on additional borrowing = 12240+6120-18000 = 360