The total investment required for a new chemical plant is estimated at $20 milli
ID: 700809 • Letter: T
Question
The total investment required for a new chemical plant is estimated at $20 million. Fifty percent will be supplied from the company's noncapital resources. Of the remaining investment one-half will come from a loan at an effective interest rate of 8 percent and one -half will come from an issue of preferred stock paying dividends at a stated effective rate of 8 percent. The income tax rate for the company is 35 percent of pretax earnings. Under these conditions. How many dollars per year does the company lose (i.e. after taxes) by issuing preferred stock at 8 percent dividend instead of bonds at an effective interest rate of 6 percent?
Explanation / Answer
total investment required = $20 million
Amount raised from non capital resources
= 0.50 * $20 million
= $10 million
Remaining investment required = $20 million - $10 million
= $10 million
Loan taken =0.50 * $10 million = $5 million
For 1 year , interest paid = $5 million x 0.08 = $0.4 million
Remaining investment required = $10 million - $5 million
= $5 million
Raised from stock paying dividends at dividend paying rate of 8%
Dividend for a year = $5 million x 0.08 = $0.4 million
Income of the company = $5 million + $0.4 million
= $5.4 million
Taxes paid = $5.4 million * 0.35 = $1.89 million
Income after taxes = $5.4 million - $1.89 million
= $3.51 million
If company raise the $5 million investment from the bonds at 6% rate Then,
Interest for a year = $5 million x 0.06 = $0.3 million
Income of the company = $5 million + $0.3 million
= $5.3 million
Taxes paid = $5.3 million * 0.35 = $1.855 million
Income after taxes = $5.3 million - $1.855 million
= $3.445 million
Company lose per year = $3.51 million - $3.445 million
= $0.065 million
= $65,000
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