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Chapter 2: Problem 11

The Shrieves Corporation has 10,000 dollar that it plans to invest in marketable securities. It is choosing between AT\&T bonds, which yield 7.5 percent, state of Florida muni bonds, which yield 5 percent, and AT\&T preferred stock, with a dividend yield of 6 percent. Shrieves' corporate tax rate is 35 percent, and 70 percent of the dividends received are tax exempt. Assuming that the investments are equally risky and that Shrieves chooses strictly on the basis of after-tax returns, which security should be selected? What is the after-tax rate of return on the highest-yielding security?

Short Answer

Expert verified
The AT&T preferred stock should be selected, offering a 5.37% after-tax return.

Step by step solution

01

Calculate After-Tax Return for AT&T Bonds

To calculate the after-tax return on the AT&T bonds, we need to account for the tax rate. The formula is:\[\text{After-tax return for bonds} = \text{Interest rate} \times (1 - \text{Tax rate})\]Given interest rate = 7.5%, Tax rate = 35%\[\text{After-tax return} = 7.5\% \times (1 - 0.35) = 7.5\% \times 0.65 = 4.875\%\]So, the after-tax return for AT&T bonds is 4.875%.
02

Calculate After-Tax Return for Florida Muni Bonds

The state of Florida muni bonds are tax-exempt, so the after-tax return is equal to the pre-tax yield since there are no taxes paid on the interest.\[\text{After-tax return for muni bonds} = 5\%\]Thus, the after-tax return for the Florida muni bonds is 5%.
03

Calculate After-Tax Return for AT&T Preferred Stock

The preferred stock dividends are 70% tax-exempt. For the remaining 30%, the corporate tax rate is applied. The formula is:\[\text{After-tax return for preferred stock} = \text{Dividend yield} \times [1 - (1 - \text{Exemption rate}) \times \text{Tax rate}]\]Given dividend yield = 6%, Exemption rate = 70%, Tax rate = 35%\[\text{After-tax return} = 6\% \times [1 - (1 - 0.70) \times 0.35]\]\[= 6\% \times [1 - 0.30 \times 0.35] = 6\% \times [1 - 0.105] = 6\% \times 0.895 = 5.37\%\]Therefore, the after-tax return for AT&T preferred stock is 5.37%.
04

Compare After-Tax Returns and Select Investment

Compare the after-tax returns of the three investments: - AT&T Bonds: 4.875% - Florida Muni Bonds: 5% - AT&T Preferred Stock: 5.37% The highest after-tax return is from AT&T Preferred Stock at 5.37%. Thus, Shrieves Corporation should invest in the AT&T preferred stock on the basis of after-tax returns.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Corporate Tax Rate
The corporate tax rate is a percentage that corporations pay on their taxable income. It's a crucial factor in determining the after-tax returns of various investments. In this exercise, Shrieves Corporation has a corporate tax rate of 35%. This rate impacts the after-tax return on investments like AT&T bonds and preferred stock dividends.

For interest income from bonds, the full corporate tax rate is applied. This means that the effective return on the investment is reduced by the corporate tax rate.
  • The after-tax yield on AT&T bonds was calculated as 4.875% when the initial yield of 7.5% was reduced by 35%.


For preferred stock dividends, there's a twist - a percentage of the dividends received is often exempt from taxes. This is where understanding corporate tax incentives becomes valuable for maximizing returns.
Preferred Stock Dividends
Preferred stock dividends offer a consistent income stream to investors. They are usually more stable than common stock dividends and provide certain tax benefits. In this exercise, the dividends from AT&T preferred stock yield 6%, but 70% of these dividends are tax-exempt.
  • This means only 30% of the dividend income is subject to the corporate tax rate of 35%.


The formula used to find the after-tax return reflects this tax exemption. The calculation shows how much of the dividend income avoids taxation, enhancing the investment appeal of preferred stocks over other securities. Understanding these exemptions is crucial for informed investment decisions and can significantly affect the overall yield.
Investment Decision-Making
Investment decision-making involves choosing options that optimize returns after accounting for taxes and risks. Here, the Shrieves Corporation wants to decide between three equally risky securities based on after-tax returns. They consider:
  • AT&T Bonds with an after-tax return of 4.875%
  • Florida Muni Bonds with a 5% tax-exempt yield
  • AT&T Preferred Stock offering a 5.37% after-tax return


By comparing these returns, the corporation identifies that the highest after-tax return is from the AT&T preferred stock. The essence of investment decision-making lies in evaluating such factors to ensure that the chosen investment provides the best financial benefit after accounting for tax implications. This step-by-step comparison highlights the importance of tax considerations in maximizing profits.

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Most popular questions from this chapter

Pearson Brothers recently reported an EBITDA of 7.5 million and 1.8 million of net income. The company has 2.0 million of interest expense and the corporate tax rate is 40 percent. What was the company's depreciation and amortization expense?

The Klaven Corporation has operating income (EBIT) of 750,000 dollar. The company's depreciation expense is 200,000 dollar. Klaven is 100 percent equity financed, and it faces a 40 percent tax rate. What are its net income, its net cash flow, and its operating cash flow?

Which of the following actions will, all else equal, increase the amount of cash on a company's balance sheet? a. The company issues 2 million dollar in new common stock. b. The company invests 3 million dollar in new plant and equipment. c. The company generates negative net income and negative net cash flow during the year. d. The company increases the dividend paid on its common stock.

The Menendez Corporation expects to have sales of 12 million dollar in 2002 . costs other than depreciation are expected to be 75 percent of sales, and depreciation is expected to be1.5 million dollar. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Menendez's federal-plus-state tax rate is 40 percent. a. Set up an income statement. What is Menendez's expected net cash flow? b. Suppose Congress changed the tax laws so that Menendez's depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow? c. Now suppose that Congress, instead of doubling Menendez's depreciation, reduced it by 50 percent. How would profit and net cash flow be affected? d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why? e. In the situation in which depreciation doubled, would this possibly have an adverse effect on the company's stock price and on its ability to borrow money?

The Herrmann Company has made 150,000 dollar before taxes during each of the last 15 years, and it expects to make 150,000 dollar a year before taxes in the future. However, in 2001 the firm incurred a loss of 650,000 dollar. The firm will claim a tax credit at the time it files its 2001 income tax return, and it will receive a check from the U.S. Treasury. Show how it calculates this credit, and then indicate the firm's tax liability for each of the next 5 years. Assume a 40 percent tax rate on all income to ease the calculations.
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