Corporation X needs 1,000,000 and can raise this through debt at an annual rate of 6 percent, or...

Question:

Corporation X needs {eq}1,000,000 {/eq} and can raise this through debt at an annual rate of {eq}6 \% {/eq}, or preferred stock at an annual cost of {eq}8 \% {/eq}. If the corporation has a {eq}21 \% {/eq} tax rate, the after-tax cost of each is {eq}\rule{1cm}{0.15mm} {/eq} .

After-Tax Cost of Capital:

Cost of capital refers to the cost that has to be borne by the company if the finance is raised through debt or equity capital. The tax has an effect on the cost of capital.

Computation of after-tax cost of capital for debt:

Rate of interest = R(d) = 6%

Income tax rate applicable = t = 21%

So, after-tax cost of debt = R(d) * (1 - t) = 6% * (1- 21%) = 4.74%

Computation of after-tax cost of preferred capital:

The rate of dividend for preferred shareholders R(p) = 8%

No tax is payable on preference shareholders' dividend as dividend is payable from the after-tax net income.

So, the after-tax cost of preferred capital is the same as 8%