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Author: rubindj One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35387  
Subject: Re: Another alternative Date: 8/14/2000 10:22 PM
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I don't understand the point you're trying to make here. To whom are dividends exluded from corporate income taxes by 70%? Are preferred dividends somehow accounted for differently than regular dividends?

Can somebody help me out here?


Any C corporation excludes 70% of any dividends (common or preferred) from income taxes. This is in comparison to interest from bonds which they must pay full taxes on. The comparison looks something like this.

ABC Insurance company is looking at investing $10,000 dollars, they have a choice of investing it in the Preferred Stock of XYZ Corporation paying 10% on Par of $100 and trading at Par of $100, or in XYZ Corporations 10% Bonds trading at 100. Here is how EAT statement is affected with the two options.

Option 1 -- Preferred Stock of XYZ Corp, $100, Par Value, Trading at 100, Paying 10% on Par.

Amount purchased -- $10,000 or 100 shares
Dividends per years -- $1,000
Corporate Income Tax 35%
Taxable amount of Dividends $300
Total Tax on Dividends $105
Total Income to Shareholders 895

Option 2, $10,000 in Bonds at 10% per year trading at 100.
Amount purchased -- $10,000 or 1 bond
Interest per year -- $1,000
Corporate Income Tax 35%
Taxable amount of Interest $1000
Total Tax on Interest $350
Total Income to Shareholders 650

Although as previously mentioned in other posts, the bonds are safer than the prefered stock due to their priority on assets and requirements for payments, much straight preferred stock is issued and valued as a bond type intstrument. When this is the case, the preferrential treatment preferred stock receives becomes a major factor in its valuation because corporations often purchase it in lieu of strait debt.

Now, to complicate matters, much preferred stock is not striaght, but rather participating or convertiable. In this case it has the ability for underlying appreciation in addition to only dividend payments and return of par value. In this case it does get valued more like the underlying common stock, with a guarenteed "kicker" of a bond, but additional saftey provided by preferred stock. In this case, individual analysis of the equity must be performed.

I'm not trying to say that investing in preferred stocks are neccisarily a bad thing, just that the old maxum of "reward is directly correlated with risk" is not shelved when dealing with these hybrid securities. Additionally, because of C corporations special advantages when dealing with preferred stocks, it rarely makes sense for indivuduals to own them when valuing them on a risk/reward continum -- there are usually bonds that will provide nearly the same return characteristics, but are less risky, or stocks that have the same risk and potentially more reward.

All this being said, this assumes the existance of an efficient market, which is less likely when dealing with these hybrid and extremely unique securities. If you believe your or your broker have special knowledge about the characteristics of a stock, then by all means, take advantage of it. But remember, it must be Unique enough to overcome the built in corporate tax advantage in addition to the efficient market.

rubindj
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