14.6Taxes and Preferred Stock

Chapter 3 noted that preferred stock is similar to a bond because it has a fixed payout.

In contrast to bonds, however, preferred shareholders cannot force the firm into bank-

ruptcy if the firm fails to meet its dividend obligation. Although the claims of a pre-

ferred stockholder are always junior to the claims of the firm’s debt holders in the event

of bankruptcy, such claims are senior to the claims of the firm’s common stockholders.

¹⁰Taxable

earnings are often very different from reported earnings. There are a number of high-tech

companies with positive reported earnings that have negative taxable earnings.

Grinblatt1051Titman: Financial	IV. Capital Structure	14. How Taxes Affect	© The McGraw1051Hill
Markets and Corporate		Financing Choices	Companies, 2002
Strategy, Second Edition

Chapter 14

How Taxes Affect Financing Choices

519

The common stockholders cannot receive a dividend until the preferred dividends

(including all past dividends) are paid. In addition, preferred shareholders, unlike debt

holders, often have voting rights.

Perhaps one of the most important differences between preferred stock and bonds

is that the dividends of preferred stock are not tax deductible, while the coupon pay-

ments of a bond are. This has led some analysts to conclude that subordinated bonds

provide cheaper financing than preferred stock. However, a feature of the U.S. tax

code provides an incentive for the use of preferred stock. For corporate holders, pre-

ferred dividends (as well as common dividends) carry a 70 percent tax exclusion. In

other words, if a corporation owns the preferred stock of another corporation, only 30

percent of the dividend received by the original corporation is taxable. Consequently,

the required yield on a firm’s preferred stock is often less than the yield on its bonds,

despite the bond’s senior status in the event of bankruptcy. Example 14.7 illustrates

this point.

Example 14.7:The Effect of Taxes on the Decision to Invest in Preferred Stock

Connolly Partners, Inc., seeks to invest excess funds in either the straight bonds or preferred

stock of Pacific Gas and Electric (PG&E).In March 1990, a 10.125 percent PG&E bond had

a yield to maturity of 9.79 percent.The 10.18 percent preferred stock, although riskier, was

yielding a 9.4 percent dividend.If Connolly’s marginal tax rate is 34 percent, which alterna-

tive will it prefer?

Answer:Connolly Partners will receive an after-tax yield of 6.46 percent (.66

9.79%)

if it invests in the bonds and an after-tax yield of 8.44 percent [(9.4%

.30

.66)

(9.4%

.70)] in the preferred stock.In this case, the preferential tax treatment gives the

firm an incentive to invest in preferred stock even though the preferred stock is riskier and

has a lower yield.

Afirm that is certain to have positive taxable earnings will have a lower after-tax

cost of capital if it issues a bond instead of preferred stock. However, if the firm is

likely to have negative taxable earnings for several years in the future, the interest tax

deduction will have no value, and preferred stock will provide the lower cost of capi-

tal. By issuing preferred stock when it cannot use the interest tax deduction, the firm

is, in a sense, selling the tax deduction that it cannot use to another firm that does have

taxable income. The firm that buys the preferred stock is willing to offer a more favor-

able borrowing rate because only 30 percent of the preferred dividend is taxable.