Question

Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers 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? Group of answer choices6.66% 6.99% 7.34% 7.71% 8.09%

Answer 1

Answer:

6.66%

Explanation:

First and foremost, if a bond is issued at par it means that the coupon rate and before-tax yield to maturity are the same. hence, in this case, the before-tax yield on the bond is 8.10%, the same as its coupon rate

after-tax yield on bond=before-tax yield*(1-tax rate)

tax rate=40%

the after-tax yield on bond=8.10%*(1-40%)

the after-tax yield on bond=4.86%

after-tax return on the preferred=the after-tax yield on bond+after-tax risk premium

after-tax risk premium=1.0%

after-tax return on the preferred=4.86%+1.0%

after-tax return on the preferred=5.86%

However, the before-tax  coupon rate on the preferred is determined below based on the dividend received deduction principle obtainable in the US

Pre-Tax Coupon Rate = after-tax return on the preferred/(1-(Tax Rate*Taxable Percentage)

The principle that 70% of dividends, that only 30% are taxable, hence, the taxable percentage is 30%

Pre-Tax Coupon Rate =5.86%/(1-(40%*30%)

Pre-Tax Coupon Rate =5.86%/0.88

Pre-Tax Coupon Rate =6.66%