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 1 percent less than that for preferred stock.

Debt can be issued at a yield of 14.4 percent, and the corporate tax rate is 35 percent. Preferred stock will be priced at $69 and pay a dividend of $6.50. The flotation cost on the preferred stock is $6.

a. Compute the aftertax cost of debt.

b. Compute the aftertax cost of preferred stock

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

Answer 1

a). Debt Yield or Before-tax cost of Debt = 14.4%

Tax rate = 35%

After-tax cost of Debt = Before-tax cost of Debt*(1-Tax Rate)

= 14.4%*(1-0.35)

= 9.36%

b). Cost of Preferred Stock = Annual Dividend/(Price - Flotation Cost)

= $6.50/($69-$6)

= 10.32%

As, Preferred Stock does not take does effect, after tax cost of Preffered Stock is 10.32%

c).

As the Treasurer assumes the aftertax cost of debt is at least 1 percent less than that for preferred stock.

Difference in aftertax cost of debt & Cost of Preferred stock = 10.32% - 9.36%

= 0.96

So, the difference in them is not at least 1%, the Facts of treasur is Incorrect

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