3. Its investment bankers have told Donner Corporation that it can issue a 25-ye

Question

3. Its investment bankers have told Donner Corporation that it can issue a 25-year, 8.1% 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 40% 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? a. 6.66% b. 6.99% c. 7.34% d. 7.71% e. 8.09%

Explanation / Answer

Its investment bankers have told Donner Corporation that it can issue a 25-year, 8.1% 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 40% tax bracket. The corporate investors require after-tax an 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?

a. b. c. d. e.

6.66%-----correct answer

6.99%

7.34%

7.71%

8.09%

Preferred yield AT = AT bond yield + RP = 5.86%

AT pfd yield = BT pfd yield BT pfd yield(1 Exclusion)(Tax rate)

Preferred yield BT = 5.86%/[1 (0.3)(0.4)] = 6.66%

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