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Chapter 5: 17BP (page 569)

The Omega Corporation has some excess cash that it would like to invest in marketable securities for a long-term hold. Its vice president of finance is considering three investments (Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent). Which one should she select based on aftertax return: (a) Treasury bonds at a 10 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 11 percent yield?

Short Answer

Expert verified

The preferred stock should be selected for investment as this security provides the highest after-tax return of 10.34%.

Step by step solution

01

Information provided in the question

Tax rate = 35%

Tax rate on dividends = 20%

Treasury bond yield = 10%

Corporate bonds yield = 13%

Preferred stock yield= 11%

02

Calculation of after-tax return of treasury bond

The after-tax return is 6.5%.

After-taxreturn=Yield脳(1-Taxrate)=10%脳(1-.35)=6.5%

03

Calculation of after-tax return of corporate bond

The after-tax return is 8.45%.

After-taxreturn=Yield脳(1-Taxrate)=13%脳(1-.35)=8.45%

04

Calculation of after-tax return of preferred stock

The after-tax return is 10.34%. The dividend of preferred stock is 70% exempt.

After-taxreturn=Yield-(Yield脳Taxableyield脳Taxrate)=11%-(11%-.3脳.20)=11%-(3.3%脳.20)=11%-0.66%=10.34%

05

Decision regarding the security to be selected

The after-tax return offered by preferred stock is 10.34% which is the highest after-tax return among the three securities, so the company should select the preferred stock for its investment.

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Most popular questions from this chapter

Question: The Bowman Corporation has a \(18 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.5 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new \)18,000,000 issue is \(530,000, and the underwriting cost on the old issue was \)380,000. The company is in a 35 percent tax bracket, and it will use an 8 percent discount rate (rounded after-tax cost of debt) to analyze the refunding decision.

c. Calculate the net present value.

Do corporations rely more on external or internal funds as sources of financing?

A financial analyst is attempting to assess the future dividend policy of Environmental Systems by examining its life cycle. She anticipates no payout of earnings in the form of cash dividends during the development stage (I). During the growth stage (II), she anticipates 12 percent of earnings will be distributed as dividends. As the firm progresses to the expansion stage (III), the payout ratio will go up to 35 percent and will eventually reach 58 percent during the maturity stage (IV).

a Assuming earnings per share will be as follows during each of the four stages, indicate the cash dividend per share (if any) during each stage.

Stage I

\(0.10

Stage II

\)1.80

Stage III

\(2.80

Stage IV

\)3.70

b. Assume in Stage IV that an investor owns 325 shares and is in a 15 percent tax bracket. What will be the investor鈥檚 after-tax income from the cash dividend?

c. In what two stages is the firm most likely to utilize stock dividends or stock splits?

Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor鈥檚 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:

Richmond

Car Rental Industry

Growth rate in earnings per share.....

15%

10%

Consistency of performance.............

Increased earnings

4 out of 5 years

Increased earnings

3 out of 5 years

Debt to total assets.....................

52%

39%

Turnover of product.........................

Slightly below average

Average

Quality of management..................

High

Average

Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor鈥檚 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?

Discuss the reason for the differences between underwriting spreads for stocks and bonds.

See all solutions

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