The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 4 percent less than that for preferred stock.

Debt can be issued at a yield of 10.0 percent, and the corporate tax rate is 40 percent. Preferred stock will be priced at $58 and pay a dividend of $5.40. The flotation cost on the preferred stock is $5.

a. Compute the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

b. Compute the aftertax cost of preferred stock.(Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

A.

After-tax cost of debt is 6.0%

B.

After-tax cost of preferred stock is 10.19%

Step-by-step explanation

A.

After-tax cost of debt is computed using the equation given below:

After-tax cost of debt = Yield × (1 - Tax rate)

                                  = 10.0% × (1 - 40%)

                                  = 10.0% × 60%

                                  = 6.0%

Hence, the after-tax cost of debt is 6.0%

B.

After-tax cost of preferred stock is computed using the equation given below:

Cost of preferred stock = Annual dividend ÷ {Current stock price - Flotation cost}

                                     = $5.40 ÷ {$58.0 - $5.0}

                                     = $5.40 ÷ $53.0

                                     = 10.18868%

Hence, the after-tax cost of preferred stock is 10.19%

Therefore, as per the assumption the after-tax cost of debt is 4.18868% (10.18868% - 6.0%) less than the after-tax cost of preferred stock.