30. Its investment bankers have told Donner Corporation that it can issue a 25 y

Question

30. Its investment bankers have told Donner Corporation that it can issue a 25 year, 8.5% annual payment
bond at par. They also stated that the company can sell an issue of annual payment preferred stock to
corporate investors who are in the 39% tax bracket. The corporate investors require an after-tax return on
the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax
risk premium. What coupon rate must be set on the preferred in order to issue it at par?

Explanation / Answer

The after tax return on the bonds is .085(1-.39)= .05185. So the preferred must have an after tax yield of .06185 So the coupon rate that must be set on the preferred to have an after tax yield of .06185 is .06185/(1-.39)= .1014 or 10.14%.

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