Kip Mole is an individual investor who is considering financing Badger's expansion.Kip's tax rates are 50% for interest income, 35% for eligible dividends, and 43% for non-eligible dividends.Which of the following statements is accurate for Kip?
A)If Badger adjusted the preferred dividend return to 10%, Kip would receive the same after-tax rate of return as the debt financing allows at 10%.
B)If Badger adjusted the preferred dividend return to 7.7% (if eligible) or 8.8% (in non-eligible), Kip would receive the same after-tax rate of return as the debt financing allows at 10%.
C)If Badger adjusted the preferred dividend return to 8.8% (if eligible) or 7.7% (in non-eligible), Kip would receive the same after-tax rate of return as the debt financing allows at 10%.
D)The rates currently offered by Badger will allow Kip to earn an equivalent after-tax rate of return on either type of investment.

Question

Quizplus · Accepted Answer

To determine the after-tax rate of return for both debt financing and preferred dividends, we need to compute the after-tax yield for both options. 
For debt financing at 10%, Kip's after-tax yield would be 5% (50% of 10%). 
For preferred dividends, we need to consider two scenarios:

1. Eligible dividends at 7.7%: Kip's after-tax yield would be 2.31% (35% of 7.7%). To match the after-tax rate of return of 5%, Badger needs to increase the preferred dividend rate.

2. Non-eligible dividends at 8.8%: Kip's after-tax yield would be 4.99% (43% of 8.8%). This is very close to the after-tax yield for debt financing at 10%. Therefore, Badger can offer preferred dividends at 8.8% (if eligible) or 7.7% (in non-eligible), and Kip would receive the same after-tax rate of return as the debt financing allows at 10%.

Option B is the correct statement.

Kip Mole Is an Individual Investor Who Is Considering Financing