Tax Preference Theory and the Cost of Equity | CFA Level 1 Exam Preparation

The Impact of Dividend Pay-out Ratio on the Cost of Equity

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Question

Suppose capital gains are taxed at 32% and realized income is taxed at 38%. The tax preference theory implies that as the dividend pay-out ratio is increased, the cost of equity:

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A. B. C. D.

B

Since the capital gains tax rate is lower than the realized income tax rate, investors would prefer to defer the realization of this income through the capital gains component. Hence, increasing the payout ratio will make the stock less attractive and depress the price, raising the cost of equity.

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