An electric utility company recently issued $25 million of mandatory redeemable preferred stock that is redeemable in 10 years. In its audit, the IRS wishes to classify the preferred stock as debt. This reclassification would mean that the dividends on the preferred stock would be reclassified as interest expense and thus would be tax deductible. The CFO is ecstatic because this will reduce the firm’s tax bill. However, he did not rise to the CFO position simply by luck and has asked you to prepare a memo explaining the pros and cons of such a reclassification. You should note that the top managers of the utility are paid a sizable bonus each year based on the firm’s earnings, that the company is planning to raise additional capital to fund expensive plant construction, and that the firm’s profitability is unchanged since it issued the preferred stock.
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