Silver Photo Studios Inc. (SPS) requires $50,000 capital for a proposed
expansion. Simon Silver, the company's president and CEO is trying to decide whether to issue preferred shares with a fixed dividend rate of 5%, or to borrow from the bank at a rate of 7%. SPS pays a corporate tax rate of 15%.
Required:

Question

Quizplus · Accepted Answer

The Answer is A) Corporate income of $3,500 ($50,000 × 7%) is required to finance the interest on the bank loan.
Corporate income of $2,941 ($50,000 × 5%)/(1 - .15) is required to finance the dividends on the preferred shares.
B) The cost of the 7% debt is 7%. (3,500/50,000) The cost of the 5% dividend is 5.9%. (2,941/50,000)