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Chapter 5: 17BP (page 569)

The Omega Corporation has some excess cash that it would like to invest in marketable securities for a long-term hold. Its vice president of finance is considering three investments (Omega Corporation is in a 35 percent tax bracket and the tax rate on dividends is 20 percent). Which one should she select based on aftertax return: (a) Treasury bonds at a 10 percent yield; (b) corporate bonds at a 13 percent yield; or (c) preferred stock at an 11 percent yield?

Short Answer

Expert verified

The preferred stock should be selected for investment as this security provides the highest after-tax return of 10.34%.

Step by step solution

01

Information provided in the question

Tax rate = 35%

Tax rate on dividends = 20%

Treasury bond yield = 10%

Corporate bonds yield = 13%

Preferred stock yield= 11%

02

Calculation of after-tax return of treasury bond

The after-tax return is 6.5%.

After-taxreturn=Yield×(1-Taxrate)=10%×(1-.35)=6.5%

03

Calculation of after-tax return of corporate bond

The after-tax return is 8.45%.

After-taxreturn=Yield×(1-Taxrate)=13%×(1-.35)=8.45%

04

Calculation of after-tax return of preferred stock

The after-tax return is 10.34%. The dividend of preferred stock is 70% exempt.

After-taxreturn=Yield-(Yield×Taxableyield×Taxrate)=11%-(11%-.3×.20)=11%-(3.3%×.20)=11%-0.66%=10.34%

05

Decision regarding the security to be selected

The after-tax return offered by preferred stock is 10.34% which is the highest after-tax return among the three securities, so the company should select the preferred stock for its investment.

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