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CMA Intermediate · Financial Management and Business Data Analytics · Cost of Capital

A data analyst compares the cost of preference capital with the after-tax cost of debt for a firm at a 25% tax rate. Which statement about preference capital is correct?

No tax adjustment is made when computing the cost of preference capital. Preference dividend is paid out of profit after tax and is not a deductible expense, so unlike interest on debt it offers no tax shield. Cost is simply dividend divided by net proceeds.

  1. AIts dividend gives a tax shield, so cost is computed as dividend x (1 - tax rate) divided by net proceeds
  2. BIts dividend is paid from post-tax profit, so no tax adjustment is made when computing its costCorrect
  3. CIts cost is always lower than the cost of equity because dividends are mandatory
  4. DIts cost is computed using the market return on the Sensex as the main input

Explanation

Preference dividend is an appropriation of profit, not an expense, so it is not tax deductible and no (1 - t) adjustment is used. Option 1 wrongly treats it like interest. Cost is based on dividend and net proceeds, not the Sensex return.

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