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%.The:
A) common stock returns 2.60% more than preferred.
B) preferred stock returns 0.34% more than common.
C) common stock returns 2.32% more than preferred.
D) returns are equal on an after-tax basis.

Question

Quizplus · Accepted Answer

For preferred stock: 
After-tax dividend = 12%*(1-0.35) = 7.80%
Total after-tax return = 7.80%
For common stock:
After-tax capital gain = 16%*(1-0.35) = 10.40%
Total after-tax return = 10.40%
Therefore, the preferred stock returns 7.80% and the common stock returns 10.40%, which is a difference of 2.60%. Therefore, the best choice is B, which says that the preferred stock returns 0.34% more than the common stock, which is not true.

Compare the After-Tax Returns for a Corporation That Invests in Preferred