Its investment bankers have told Buger King that it can issue a 25-year, 8.1% an

Question

Its investment bankers have told Buger King that it can issue a 25-year, 8.1% annual payment bond at par. They also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par? (show work)

Explanation / Answer

              
   The after tax return on the bonds = Coupon Rate (1- Debt)          
   The after tax return on the bonds = 0.081*(1-0.40) = 4.9%      
              
   Preferred Stock after tax yield = After Tax Return on bonds + Premium          
   Preferred Stock after tax yield   = 4.9 + 1.0 = 5.9%   

   Coupon Rate that must be set on the preferred to have an after tax yield of .059 =0.059 / (1-0.40) = 9.9%
              

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