If a corporation can issue preferred stock instead of bonds, what must it do to maintain the same after-tax income?

If a corporation can issue preferred stock instead of bonds, what must it do to maintain the same after-tax income?

• A. Increase taxable income to cover dividends
• B. Decrease taxable income to cover interest
• C. Maintain taxable income at the same level
• D. Issue more bonds to offset dividends

Answer: (A)

To maintain the same after-tax income when a corporation opts to issue preferred stock instead of bonds, it is essential to recognize the differing tax treatments of these financial instruments. Preferred stock dividends are paid from after-tax profits and are not tax-deductible by the issuing corporation, whereas interest on bonds is tax-deductible. If a corporation chooses to issue preferred stock, it will not benefit from the interest tax shield that bondholders enjoy. This means that, to achieve the same after-tax income, the company would need to generate a higher taxable income to support the payment of preferred dividends. By increasing taxable income, the corporation can cover the obligation of preferred stock dividends with the after-tax earnings that arise from the increased pre-tax income. Maintaining taxable income at the same level, as suggested by another option, would not suffice since it would result in lower after-tax income due to the non-deductibility of preferred dividends. Thus, to account for the payment of dividends on preferred stock, increasing taxable income is the necessary action to preserve the same after-tax income.

To maintain the same after-tax income when a corporation opts to issue preferred stock instead of bonds, it is essential to recognize the differing tax treatments of these financial instruments. Preferred stock dividends are paid from after-tax profits and are not tax-deductible by the issuing corporation, whereas interest on bonds is tax-deductible.

If a corporation chooses to issue preferred stock, it will not benefit from the interest tax shield that bondholders enjoy. This means that, to achieve the same after-tax income, the company would need to generate a higher taxable income to support the payment of preferred dividends. By increasing taxable income, the corporation can cover the obligation of preferred stock dividends with the after-tax earnings that arise from the increased pre-tax income.

Maintaining taxable income at the same level, as suggested by another option, would not suffice since it would result in lower after-tax income due to the non-deductibility of preferred dividends. Thus, to account for the payment of dividends on preferred stock, increasing taxable income is the necessary action to preserve the same after-tax income.