Answer to Question #178001 in Finance for Doa

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 incometax rate for the company is 35 percent of pretax earnings. Under these conditions, how many dollars per year does the company actually lose (i.e., after taxes) by issuing preferred stock at 8 percent dividends instead of bonds at an effective interest rate of 6 percent? 

Answer 1

total investment required = $\$20$ million Amount raised from non capital resources = $0.50 × \$20 million = \$10 million$

Remaining investment required=$\$20million-\$10milion=\$10million$

Loan interest

$0.08×\$5million=\$0.4million$

Preffered stock

$0.08×\$5million=\$0.4million$

Tax

$0.35×\$20million=\$7million$

Dollars lost per year=$\$(0.4+0.4+7)million=\$7.8million$