Question

Corporation X needs $1,000,000 and can raise this through debt at an annual rate of 10 percent, or preferred stock at an annual cost of 7 percent. If the corporation has a 40 percent tax rate, the after-tax cost of each is___________.A) debt: $100,000; preferred stock: $70,000B) debt: $60,000; preferred stock: $42,000C) debt: $60,000; preferred stock: $70,000D) debt: $100,000; preferred stock: $42,000

Answer 1

Answer:

Option C is the correct answer,$60000 after tax cost of debt and $70000 cost of preferred stock.

Explanation:

The after tax cost of debt is the interest payable multiplied by(1-t), where represents the tax rate which is 40%

Interest is $1000000*10%=$100000

$100000(1-0.40)=$60000

Since preferred  stock is not tax deductible, the cost of preferred stock is the yearly dividends.

Dividends on preferred stock=7%*$1000000

                                                 =$70000

As a result, the after tax cost of debt is $60000 and $70000 for preferred stock.