Garnet Corporation is considering issuing risk-free debt or risk-free preferred stock. The tax rate on interest income is 35%, and the tax rate on dividends or capital gains from preferred stock is 15%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 40%.
a. If the risk-free interest rate for debt is 6%, what is the cost of capital for risk-free preferred stock?
b. What is the after-tax debt cost of capital for the firm? Which security is cheaper for the firm?
c. Show that the after-tax debt cost of capital is equal to the preferred stock cost of capital multiplied by (1 - t*).