Question

The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 3 percent less than that for preferred stock.

Debt can be issued at a yield of 11.0 percent, and the corporate tax rate is 20 percent. Preferred stock will be priced at $60 and pay a dividend of $6.40. The flotation cost on the preferred stock is $6.

a. Compute the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Compute the aftertax cost of preferred stock. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
c. Based on the facts given above, is the treasurer correct?

Answer 1

a. Compute the after tax cost of debt.

after tax cost of debt = 11% x (1 - tax rate) = 11% x 0.8 = 8.8%

b. Compute the after tax cost of preferred stock.

after tax cost of preferred stock = cost of preferred stock (no taxes are deducted for paying preferred dividends since they are paid in capital)

cost of preferred stocks = $6.40 / ($60 - $6) = $6.40 / $54 = 11.85%

c. Based on the facts given above, is the treasurer correct?

the difference = 11.85% - 8.8% = 3.05%, so the treasurer was right