Plowman Industries 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 after-tax return on the bonds is 8.1% * (1 - 40%) = 4.86%. The after-tax return on the preferred must be 4.86% + 1.0% = 5.86%. The coupon rate on the preferred must be 5.86% / (1 - 40%) = 6.66%.

Plowman Industries Can Issue a 25-Year, 8