The after-tax cost of preferred stock is always: A) higher than the cost of common shares. B) less than the after-tax cost of debt. C) less than the before-tax cost of preferred stock. D) equal to the before-tax cost of preferred stock.
D) no tax benefits for the issuer of preferred stocks
Wow this got me thinking. I think it is C. For example, if the cost of preferred stock was 10% i.e. you need to pay 10% preferred dividends to preferred stock holders and this interest expense (to the issuer) reduces the taxable income (of the issuer), so in a way the cost of after-tax PS will be less than what it will be before-taxes. - Dinesh S
any other takers? I’ll post the answer shortly.
I think it’s D. There is no tax effect when we consider cost of preffered stock.
I would go with C for the same reason that Dinesh stated.
I’m not sure if there is such things as before-tax cost of preferred stock because dividents are always after-tax. I guess we could define before-tax cost of preferred stock as (divident/preferred stock price)/(1-average tax rate) but I don’t see value of doing that.
alpenchev is on a roll. The correct answer is D. You guys are right, the after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.
I also think it’s D. Dividends on preferred stock are paid with after-tax net income so I don’t see really see how there is a difference between before-tax and after-tax. They should be equal, right?
Wow, thanks lola!! lola Wrote: ------------------------------------------------------- > alpenchev is on a roll. > because preferred stock dividends are not tax deductible. Didn’t knew this… > The cost of preferred shares is usually higher than the cost of debt, Didn’t knew this either… - Dinesh S
Why is the cost of preferred shares less than the cost of common shares?
because there is a complete process of finding the right ibanker, underwriting, red hering prospectus, etc… etc… to be followed… - Dinesh S
Shreya - I would say the cost of PS is less b/c div’s are set by issue, and they are paid regularly. Plus PS holders have a higher claim in the liquidation chain than CS. So in theory it should be a safer investment than CS and receive a lower risk premium.
Bodymore: That makes sense. So what you’re saying is that PS have a set amount of dividend- eg. 10% of after tax profits annually, or some such thing? So it is not at the discretion of the Mgmt… But when you talk of “cost” of PS…you’re referring to cost to issuer or to the buyer? Why would the cost to issuer be less than that of common stock?
PS dividends are set at a % of par value. So they don’t fluctuate like a lot of CS div’s. As far as the cost to the issuer, I think my logic still stands, but what Dinesh said might factor in as well. I am thinking that any time a company raises capital, the more risky the issue, the more they are going to have to pay to issue it. Whether that payment comes in the form of higher div’s, higher interest payments, etc. So, since PS gets a guaranteed div, and a higher claim in the liquidation chain, there is less risk to the purchaser and should cost less to issue. Someone correct me if I am wrong.
Agree with Bodymore. I think it’s safe to note that cfai rarely focuses on market frictions (costs of issuance, bid/ask spreads, etc.) when comparing different funding instruments (up and down the capital structure). So I’d say the quick answer is bkrpt priority. Pragmatically, preferred’s usually appear with < 10% coupon; cost of common equity is usually over 10%.