Garnet Corporation is considering issuing risk-free debt, or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 15%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 40%.

a. If the risk-free interest rate for debt is 6%, what is cost of capital for risk-free preferred stock?

b. What is the after-tax debt cost of capital for the firm? Which security is cheaper for the firm?

c. Show that the after-tax debt cost of capital is equal to the preferred stock cost of capital multiplied by (1 - τ*).

Question

Gauge Carey

Business

4 October, 12:49

Garnet Corporation is considering issuing risk-free debt, or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 15%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 40%.

a. If the risk-free interest rate for debt is 6%, what is cost of capital for risk-free preferred stock?

b. What is the after-tax debt cost of capital for the firm? Which security is cheaper for the firm?

c. Show that the after-tax debt cost of capital is equal to the preferred stock cost of capital multiplied by (1 - τ*).

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Answers (1)

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Tianna Bradley · Answer 1

a) investors wil receive 6% x (1-0.35)

= 3.9% risk free debt after tax.

After tax return from risk free preferred stock earnings must be equal.

to evaluate the cost of capital fro preferred stock = 3.9% / (1-0.15)

= 4.59%

b) the after-tax debt cost of capital = 6% x (1 - 0.40)

= 3.60%.

therefore, 3.60% is cheaper than the 4.59% preffered stoch cost per capital

c) r * = 1 - [{ (1 - 0.40) (1 - 0.15) } / (1 - 0.35) ] = 1 - 0.7846 = 0.2154, or 21.54%

Hence, 4.59% x (1 - 0.2154) = 3.60%