Question

Compare the after-tax returns for a corporation that invests in preferred stock with a 12% dividend versus a common stock with no dividend but a 16% capital gain. The corporation's tax rate is 35%.

Answer 1

Here we need to compare after tax return for dividend on preference shares and capital gain tax on equity

After tax return = Before tax return(1-tax rate)

For equity:

After tax return = Before tax return(1-tax rate)

After tax return = 16%(1-0.35)

=16%(0.65)

=10.40%

For dividend on preference shares

Dividend on preference shares are 70% exempt , thus only 30% are taxable, hence

After tax return for prefernce shares = 12% - (12% x 30% x 35%)

= 12% - 1.26%

=10.74%

Henec After tax return of preference shares is more than after tax return on capital gain of equity shares by 10.74% - 10.40% = 0.34%