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Question: The treasurer of Kelly Bottling Company (a corporation) currently has \(150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying \)150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent.

b. Compute the after-tax borrowing cost to purchase the additional preferred stock. That is, multiply the interest cost times (1 - T).

Step by step solution

01

Step-by-step solutionStep 1: Information provided in the question

Funds to be borrowed = $150,000

Cost of borrowing = 13%

02

Calculation of after-tax borrowing cost

The after-tax borrowing cost is $12,675.

$\begin{array}{c}\mathbf{Interest}\mathbf{=}\mathbf{Loan}\mathbf{}\mathbf{amount}\mathbf{×}\mathbf{Interest}\mathbf{}\mathbf{rate}\\ \mathbf{=}\mathbf{\$}\mathbf{150}\mathbf{,}\mathbf{000}\mathbf{×}\mathbf{13}\mathbf{\%}\\ \mathbf{=}\mathbf{\$}\mathbf{19}\mathbf{,}\mathbf{500}\end{array}$

$\begin{array}{c}\mathbf{After}\mathbf{-}\mathbf{taxborrowingcost}\mathbf{=}\mathbf{Interestexpense}\mathbf{×}\left(1-T\right)\\ \mathbf{=}\mathbf{\$}\mathbf{19}\mathbf{,}\mathbf{500}\mathbf{×}\left(1-35\%\right)\\ \mathbf{=}\mathbf{\$}\mathbf{19}\mathbf{,}\mathbf{500}\mathbf{×}\mathbf{65}\mathbf{\%}\\ \mathbf{=}\mathbf{\$}\mathbf{12}\mathbf{,}\mathbf{675}\end{array}$

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