The treasurer of Kelly Bottling Company (a corporation) currently has $150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying $150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at20 percent.
a. Compute the amount of the aftertax income from the additional preferred stock if it is purchased.
b. Compute the aftertax borrowing cost to purchase the additional preferred stock. That is, multiply the interest cost times (1 – T).
c. Should the treasurer proceed with his proposal?
d. If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what impact will this have on the outcome?