The treasurer of Kelly bottling co (a corporation) currently has $240,000 invest

Question

The treasurer of Kelly bottling co (a corporation) currently has $240,000 invested in preferred stock yielding 8%. He appreciates the tax advantages of preferred stock and is considering buying $240,000 more with borrowed funds. The cost of the borrowed funds is 10%. He suggests this proposal to his board of directors. They are somewhat concerned by the fact hat the treasurer will be paying 2% more for funds than the company will be earning on the investments. Kelly bottling is in a 34% tax bracket, with dividends taxed at 15%.

a. Compute the amount of the aftertax income from the additional preferred stock if it is purchased.

b. Compute the aftertax borrowing cost to purchase the additional preferred stock

c. Should the treasurer proceed with his proposal?

Explanation / Answer

a) after tax income = 240000 * 8% * (1-15%) = 16320

b) after borrowing cost = 240000 * 10% * (1-34%) = 15840

c) net income = 16320 - 15840 = 480

since net incomeispositive ...treasurer shouldproceed with his proposal

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