Problem:
The treasurer of Harmon Bottling Company currently has $100,000 invested in preferred stock yielding 9%. He appreciates the tax advantages of preferred stock and is considering buying $100,000 more with borrowed funds. The cost of the borrowed funds is 11%. He suggests this proposal to his board of directors. The directors are somewhat concerned by the fact that the treasurer is paying 2% more for funds than he is earning. The firm is in a 34% tax bracket.
1) Compute the amount of the aftertax income from the additional preferred stock if it is purchased.
2) Compute the aftertax borrowing cost to purchase the additional preferred stock. That is, multiply the interest cost times (1-tax)
3) Should the treasurer proceed with his proposal?
4) If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what effect will this have on the outcome?