This answer results from calculating the cost of the preferred stock as if the preferred dividend were tax-deductible. Dividends paid are not tax-deductible, so the dividend rate should not be adjusted for taxes.
The after-tax interest rate on the bonds will be 70% of 7% (.70 × [1 ? .30]), or 4.9%. The after-tax cash outflow for interest in the second year after issue will be $50,000,000 × .049, or $2,450,000. The cash outflow for dividends on the preferred stock in the second year after issue will be $50,000,000 × .05, or $2,500,000. Thus the net cash flow for the second year after issue with the bond issue will be $50,000 higher. In other words, the net cash benefit of selling the bonds instead of the preferred stock will be $50,000. Because the cost of capital for the bonds will be 4.9% versus 5% for the preferred stock, the cost of the bonds will be $50,000 lower than the cost of the preferred stock, so the cash flow with the bond issue will be $50,000 higher.
This answer results from using a 35% effective tax rate to adjust the bond interest and using a 30% tax rate to adjust the preferred stock dividend. The effective tax rate for the bond interest is 30%, and the preferred dividend should not be adjusted at all because dividends are not tax deductible.
This answer results from using a 35% effective tax rate. The effective tax rate is 30%.
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