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Investment in preferred stock

The treasurer of Harmon Bottling Company currently has $100,000 invested in preferred stock yielding 9%. He appreciates the tax advantages of preferred stock and is considering buying $100,000 more with borrowed funds. The cost of the borrowed funds is 11%. He suggests this proposal to his board of directors. The directors are somewhat concerned by the fact that the treasurer is paying 2% more for funds than he is earning. The firm is in a 34% tax bracket.

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-tax)

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 effect will this have on the outcome?

Solution Preview

a) Compute the amount of the aftertax income from the additional preferred stock if it is purchased.

70% of dividends are exempt from tax and tax is to be paid in remaining 30% of dividend income. The total dividend income on $100,000 of preferred stock is 100,000 X 9%=$9,000. Tax is to be paid on 9,000X30%=2,700 and the tax amount is 2,700X34% = $918. The after tax income from the ...

Solution Summary

The solution explains the impact of investing in a preferred stock

$2.19