Solarcell Corporation has $20,000 which it plans to invest in marketable securit

Question

Solarcell Corporation has $20,000 which it plans to invest in marketable securities. It is choosing between AT&T bonds which yield 11%, State of Florida municipal bonds which yield 8%, and AT&T preferred stock with a dividend yield of 9%. Solarcell's corporate tax rate is 40%, and 70% of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security.

Explanation / Answer

Solution:

Evaluation of different plans to invest:

If invested in AT&T Bonds Yield 11%, and after tax return = 11% (1-Tax Rate) = 11% x 0.60 = 6.60%

If invested in State of Florida Municipal Bonds which yield 8% --- State Municipal bonds are tax free bonds and there will be no tax on these bonds. Therefore the After Tax Return on this Bond = 8%.

If Invested in AT & T Preferred Stock

Tax Free Return = 9% x 075 = 6.75%

After Tax Return = 9% x 0.25 x (1-0.40) = 1.35%

Total After Tax Return = 1.35% + 6.75% = 8.10%

From the above calculation it is clear that investment in AT&T Preferred Stock is more beneficial instead of investing in Municipal Bonds and AT&T Bonds.

Hence, Preferred Stock of AT&T will give after tax rate of return 8.10% which is the Highest Yielding security.

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