The Stuart Corporation has excess cash to invest in one of two securities. The company's tax rate is 40 percent. The first alternative is a 10-year, 10 percent coupon bond (with semiannual interest payments) that has a current price of $1,000 and a yield of 10 percent. The second alternative is the preferred stock of Pickett Corp. which promises to pay a before-tax return of 9 percent. What is the after-tax nominal return of the better investment alternative?

Question

Quizplus · Accepted Answer

The bond's interest is taxable, so the after-tax return is 10% * (1 - 0.40) = 6%. The preferred stock's dividends are taxed at a lower rate, so the after-tax return is 9% * (1 - 0.15) = 7.65%. However, the tax rate for dividends is not provided, so assuming the full tax rate, the after-tax return is 9% * (1 - 0.40) = 5.4%. The bond is better with 6%, but the correct calculation for the preferred stock should be 9% * (1 - 0.15) = 7.65%, which is not an option. Therefore, the bond's after-tax return is 6%, but the closest option is 7.92% for the preferred stock assuming a lower tax rate on dividends.

The Stuart Corporation Has Excess Cash to Invest in One