Buggy Whip Manufacturing Company is issuing preferred stock yielding 10%. Selten

Question

Buggy Whip Manufacturing Company is issuing preferred stock yielding 10%. Selten Corporation is considering buying the stock. Buggy's tax rate is 0% due to continuing heavy tax losses, and Selten's tax rate is 34%. What is the after-tax preferred yield for Selten?
Question options:

1) 3.4%

Buggy Whip Manufacturing Company is issuing preferred stock yielding 10%. Selten Corporation is considering buying the stock. Buggy's tax rate is 0% due to continuing heavy tax losses, and Selten's tax rate is 34%. What is the after-tax preferred yield for Selten?
Question options:

1) 3.4%

2) 6.6%

3) 8.98%

4) 10.0%

Please explain how to work this one out. I had chosen 6.6% but the instructor said it is wrong. I am not sure how to calculate this.

3) 8.98%

4) 10.0%

Explanation / Answer

according to U.S. laws 80% of inter-company preferred dividends are tax exempt. for simplicity lets say that selden receives a $100 dividend, then the first $70 would be tax exempt and on the remaining $20 they would receive: $30 * (1-tax rate), in this case 30*(1-0.34) = $19.8 So total they would receive = 70+19.8 = 89.8 making their after tax return equal to 89.8/100 = 89.8% now that we have this we can use it to find the after tax yield of the stock in question 10% * 93.2% = 8.98%, ( a word of warning here, the tax deductible amount is based on the ownership in the company paying the dividend. In this case it is assumed that the Selden will own less than 20% of Buggy, if they owned between 20-80% they would be able to deduct 80% of the dividend.)

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