Question

The Omega Corporation has some excess cash it would like to invest in marketable securities for a long-term hold. Its Vice-President of Finance is considering three investments: (a) Treasury bonds at a 6 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 10 percent yield. Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent.

a-1. Compute the aftertax yields for the three investment options.
Note: Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.

Answer 1

The after-tax yields for Omega Corporation's investment options in Treasury bonds, corporate bonds, and preferred stock are 3.90%, 8.45%, and 8.00%, respectively, with corporate bonds offering the highest after-tax yield.

Step-by-step explanation:

The student has asked how to compute the after-tax yields for three different types of investment options: Treasury bonds, corporate bonds, and preferred stock. To make an accurate comparison between these investment opportunities, we need to consider how taxes affect the yield from each option, given the Omega Corporation's tax bracket and the applicable tax rates on dividends.

To compute the after-tax yield for Treasury bonds at a 6 percent yield in a 35 percent tax bracket, the calculation is as follows:

After-tax yield = Yield * (1 - Tax rate)

After-tax yield = 6% * (1 - 0.35) = 3.90%

For corporate bonds at a 13 percent yield:

After-tax yield = 13% * (1 - 0.35) = 8.45%

And for preferred stock with a 10 percent yield, since dividends are taxed differently:

After-tax yield = Yield * (1 - Tax rate on dividends)

After-tax yield = 10% * (1 - 0.20) = 8.00%

Therefore, corporate bonds offer the highest after-tax yield for Omega Corporation, despite their higher risk relative to Treasury bonds.