Question

A company has the option of offering long-term debt with an interest cost of 12.0%, or preferred shares with an interest cost of 10.5%. Assume the corporate tax rate is 21%. Compare the before-tax and after-tax cost of both the long-term debt and the preferred shares.

Which is less expensive in each case (before-tax and after-tax)?

Justify your answer.

Answer 1

Preferred Stock is not tax deductible

Hence, for preffered shares before-tax=after-tax=10.5%

Before-tax cost of long -term debt=12%
After-tax cost=before-tax cost*(1-tax rate)=12%*(1-21%)=9.48%

Before-tax: Preferred stock less expensive
After-tax: Long term debt less expensive

As debt has interest payments which are tax deductibel, they are preferrable after-tax