This essay focuses on average of the borrowed money. The result is an average cost of these two sources of $140,000/$1,550,000, or approximately 9%.
What was the cost to Henderson of each of these sources? The cost of the money provided by the preferred stockholders is clearly the amount of dividends of $50,000. The cost as a percentage is $50,000/$500,000, or 10%. The average cost of the borrowed money can be approximated by dividing the 2017 interest expense of $140,000 by the average of the notes payable and bonds payable of $1,550,000. The result is an average cost of these two sources of $140,000/$1,550,000, or approximately 9%.
The concept of leverage refers to the practice of using borrowed funds and amounts. It is received from preferred stockholders in an attempt. This is to earn an overall return that is higher than the cost of these funds. Recall the rate of return on assets for 2017: 11.8%. Because this return is on an after-tax basis, it is necessary for comparative purposes to convert the average cost of borrowed funds to an after-tax basis. Although we computed an average cost for borrowed money of 9%, the actual cost of the borrowed money is 5.4% [9% × (100% − 40%)] after taxes. Because dividends are not tax-deductible, the cost of the money provided by preferred stockholders is 10%, as calculated earlier.