Question

Question: The treasurer of Kelly Bottling Company (a corporation) currently has \(150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying \)150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent.

d. If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what impact will this have on the outcome?

Short answer

Answer

The increase in interest rate and dividend yield will reduce the portfolio’s value and increase the cost of borrowing.

Step-by-step solution

Step-by-step solutionStep 1: Meaning of bond yield

The bond yield refers to the return that the bondholder will generate from a bond. The bond yield can be calculated by using the coupon rate and face value of the bond.

Impact of interest rate and dividend yield

The increase in the dividend yield will reduce the value of the portfolio and the cost of borrowing can increase.The increase in the interest rates will reduce the price of the bonds as the bondholders will want to sell their bonds at high prices in the market and this will inversely impact its prices.