A corporation has $10,000,000 in 10 percent preferred stock outstanding and a 40 percent tax rate.The amount of earnings before interest and taxes (EBIT) required to pay the preferred dividends is_________.
A) $1,000,000
B) $600,000
C) $400,000
D) $1,666,667

Question

Quizplus · Accepted Answer

The annual preferred dividend payment is 10% of the preferred stock outstanding, which is:

$10,000,000 x 10% = $1,000,000

However, since the corporation has a 40% tax rate, it can only deduct 60% of this preferred dividend payment from its taxable income. Therefore, the after-tax cost of the preferred dividends is:

$1,000,000 x (1 - 0.4) = $600,000

To determine the EBIT required to pay this after-tax cost of preferred dividends, we can use the formula:

EBIT - Interest - Taxes = Net Income

Since there is no interest expense in this scenario, the formula simplifies to:

EBIT - Taxes = Net Income

We can rearrange this formula to solve for EBIT:

EBIT = Net Income + Taxes

Since the after-tax cost of the preferred dividends is $600,000, the net income required to pay this cost is:

$600,000 / (1 - 0.4) = $1,000,000

Therefore, the EBIT required to pay the after-tax cost of the preferred dividends is:

EBIT = $1,000,000 + (0.4 x $1,000,000) = $1,400,000

Finally, we need to add back the before-tax cost of the preferred dividends to get the total EBIT required to pay the preferred dividends:

$1,400,000 + $400,000 = $1,800,000

Therefore, the amount of EBIT required to pay the preferred dividends is $1,800,000, which is closest to choice D ($1,666,667).

A Corporation Has $10,000,000 in 10 Percent Preferred Stock Outstanding