Tax effect on dividends (CFAI question)

CFA Level I
#1

From a CFAI exam… XXX energy is planning a new issue of $100 par preferred stock with a 12 percent dividend. The stock can be sold for $95 per share. Assuming a marginal tax rate of 40 percent, the after-tax component cost of preferred stock will be closest to: A. 7.2% B. 7.6% C. 12.0% D. 12.6%

#2

The correct answer is D, and the explanation is:- Dividends are not tax deductible. The after-tax component cost of preferred stock = (100 x 0.12) / 95 = 12.63% My question is, if dividends are not tax deductible, then where is the tax factored into the calculation?

#3

The dividends paid on the preferred will be paid out of after-tax dollars. So dividing the dividend by the price yields the after tax cost.

#4

ah, ok. Thanks. I’ll go over that…

#5

The tax rate is a favorite distractor in WACC questions, especially for preferred stock. I used to see that a lot in college.