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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Which of the following is generally the cheapest source of long-term finance for a profitable company, taking account of how each source is treated for corporate tax?

Secured debt is generally the cheapest source because lenders face lower risk and accept a lower return, and interest is normally tax deductible. Dividends on ordinary and preference shares are paid from post-tax profit and give no tax shield.

  1. ARetained earnings, because no tax relief applies and no flotation costs arise
  2. BOrdinary shares issued through a rights issue, because dividends are tax deductible
  3. CIrredeemable preference shares, because their dividends are tax deductible
  4. DSecured debt, because interest is normally deductible and lenders rank ahead of shareholdersCorrect
  5. Convertible preference shares, because they carry no conversion option value

Explanation

Lenders bear less risk because they rank ahead of shareholders and are secured, so they require a lower return. Interest is also normally deductible against taxable profit, lowering the after-tax cost further. Equity dividends and preference dividends are paid out of post-tax profits, so no tax shield arises on them.

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