Garnet Corporation is considering issuing risk-free debt, or risk-free preferred stock. The tax rate on interest income is 42%, and the tax rate on dividends or capital gains from preferred stock is 25%. However, the dividends on preferred stock are not deductible for corporate tax purposes, and the corporate tax rate is 38%.
a. If the risk-free interest rate for debt is 9%, what is 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. Is the after-tax debt cost of capital equal to the preferred stock cost of capital multiplied by
(1−τ*)