Problem:

The treasurer of Kelly bottling co (a corporation) currently has $240,000 invested in preferred stock yielding 8%. He appreciates the tax advantages of preferred stock and is considering buying $240,000 more with borrowed funds. The cost of the borrowed funds is 10%. He suggests this proposal to his board of directors. They are somewhat concerned by the fact hat the treasurer will be paying 2% more for funds than the company will be earning on the investments. Kelly bottling is in a 34% tax bracket, with dividends taxed at 15%.

Required:

Question 1: Compute the amount of the aftertax income from the additional preferred stock if it is purchased.

Question 2: Compute the aftertax borrowing cost to purchase the additional preferred stock

Question 3: Should the treasurer proceed with his proposal?

Note: Provide support for your underlying principle.