Question

National Business Machine Co. (NBM) has $4.3 million of extra cash after taxes have been paid. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in either Treasury bills yielding 2.1 percent or a 4.5 percent preferred stock. IRS regulations allow the company to exclude from taxable income 50 percent of the dividends received from investing in another company’s stock. Another alternative is to pay out the cash now as dividends This would allow the shareholders to invest on their own in Treasury bills with the same yield or in preferred stock. The corporate tax rate is 23 percent. Assume the investor has a 33 percent personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 20 percent on common stock dividends.

Suppose the company reinvests the $4.3 million and pays a dividend in three years.
a-1.	What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)
a-2.	What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Suppose instead that the company pays a $4.3 million dividend now and the shareholder reinvests the dividend for three years.
b-1.	What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)
b-2.	What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

a-1). Extra cash = 4,300,000

After-tax return on T-bills = annual return*(1-corporate tax rate) = 2.1%*(1-23%) = 1.62%

Amount after 3 years = 4,300,000*(1+return)^3 = 4,300,000*(1+1.62%)^3 = 4,511,984.13

After-tax cash flow to shareholders = amount after 3 years*(1- personal dividend tax rate) = 4,511,984.13*(1-20%)

= 3,609,587.30

a-2). After-tax annual return earned on preferred dividends = annual return*(1 - corporate tax rate*%age of dividends included in taxable income) = 4.5%*(1 - 23%*50%) = 3.98%

Amount earned after 3 years = 4,300,000*(1+3.98%)^3 = 4,834,473.90

After-tax cash flow to shareholders = amount after 3 years*(1-personal dividend tax rate)

= 4,834,473.90*(1-20%) = 3,867,579.12

b-1). If the company pays dividends now then the after-tax dividend to the shareholders is

extra cash*(1 - personal dividend tax rate) = 4,300,000*(1-20%) = 3,440,000

After-tax return earned by shareholders = annual return*(1-personal income tax rate) = 2.1%*(1-33%) = 1.41%

Amount earned in 3 years = 3,440,000*(1+1.41%)^3 = 3,587,254.98

b-2). After-tax dividend paid to shareholders = 3,440,000

After-tax return earned by shareholders = annual return*(1-personal income tax rate) = 4.5%*(1-33%) = 3.02%

Amount earned in 3 years = 3,440,000*(1+3.02%)^3 = 3,760,623.39