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The treasurer of Kelly Bottling Company (a corporation) currently has $190,000 invested in preferred stock yielding 9 percent. He appreciates the tax advantages of preferred stock and is considering buying $190,000 more with borrowed funds. The cost of the borrowed funds is 11 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 2 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 10 percent.
Question a) Compute the amount of the aftertax income from the additional preferred stock if it is purchased.
Question b) Compute the aftertax borrowing cost to purchase the additional preferred stock.
Question c) Should the treasurer proceed with his proposal? (Yes or no)
Question d) If market interest rates and dividend yields increase six months after a purchase decision is made, will the impact of those increases be favorable or unfavorable for the firm?
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