Because 50% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be

Cost of equity = r_s(0.30)(0.50) + r_ps(1 − T)(0.50)(0.50).

Question

Quizplus · Accepted Answer

The formula provided in the question is not accurate. The correct formula to calculate the cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends would take into account the after-tax cost of the preferred dividends, which is not reflected in the formula provided. Therefore, a more accurate formula would be:

Cost of equity = rS1U1B1sS1U1B0(1 - Wp) + rp(1 - T)(Wp)

Where: 
rS1U1B1s = cost of common equity 
Wp = proportion of total earnings paid out as preferred dividends 
rp = cost of preferred equity 
T = tax rate

Since the formula provided in the question is not accurate, the answer is B) False.

Because 50% of the Preferred Dividends Received by a Corporation