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?

Question

Quizplus · Accepted Answer

The correct answer is A because the after-tax return on the preferred stock must be 1.0% higher than the after-tax return on the bonds. The after-tax return on the bonds is 8.1% * (1 - 40%) = 4.86%. Therefore, the after-tax return on the preferred stock must be 4.86% + 1.0% = 5.86%. To issue the preferred stock at par, the coupon rate must be set at 5.86% / (1 - 40%) = 6.66%.

Its Investment Bankers Have Told Donner Corporation That It Can