Final answer:
To determine the yield required on auction-rate preferred stock, calculate the commercial paper rate's after-tax cost given the tax rate and compare it to the potential investment. The after-tax cost of 10.8% commercial paper with a 35% tax rate is approximately 7.02%. Therefore, considering default risks are the same, the corporation would require a yield close to 7.1%, which is option (d).
Step-by-step explanation:
To find the yield that a corporation would require on an investment in auction-rate preferred stock, we must first acknowledge that the cost of debt (after tax) is often compared to the cost of equity to determine the attractiveness of different investment opportunities. Given the short-term commercial paper rate of 10.8 percent and a corporate tax rate of 35 percent, we can calculate the after-tax cost of debt to make an appropriate comparison to the auction-rate preferred stock, which is an equity investment. The calculation for the after-tax yield on debt is as follows:
After-tax cost of debt = Interest rate × (1 - Tax rate)
The after-tax cost of debt can be calculated as 10.8% × (1 - 0.35), which equals 7.02% when rounded to the nearest hundredth of a percent. This figure represents the yield a corporation would be indifferent to when choosing between the given commercial paper rate and a tax-free investment.
Auction-rate preferred stock usually pays dividends that are tax-free for the corporate investor, therefore the comparison should be made using the after-tax yield on debt. Considering that the default risk is the same for commercial paper and auction-rate preferred stock, the calculation suggests that a corporation would require a yield of approximately 7.0%, as the undiluted interest rate is already net of taxes. Hence, the closest answer that aligns with our calculation is option d. 7.1 percent.