Question

after completing its capital spending for the year, carlson manufacturing has $1,800 extra cash. carlson's manager must choose between investing the cash in treasury bonds that yield 3 percent or paying the cash out to investors who would invest in the bonds themselves. a. if the corporate tax rate is 23 percent, what personal tax rate would make the investors equally to receive the dividend or to let carlson invest the money? b. id the answer to (a) reasonable? c. suppose the only investment choice is a preferred stock that yields 6 percent. the corporate dividend exclusion of 50 percent applies. what personal tax rate will make the stockholders indifferent to the outcome of carlson's dividend decision? d. is this a compelling argument for a low dividend-payout ratio?

Answer 1

1. Calculation of the Personal Tax Rate:

Let x be the ordinary income tax rate. The individual receives an after-tax dividend of:

After - Tax dividend =$1800(1-x)

Which she invests in Treasury bonds. The Treasury bond will generate after tax cash flows to the investor of:

After tax cash flow from treasure bonds = $1800(1-x)[1+0.03(1-x)]

If the firm invests the money, its proceeds are:

Firm proceeds = $1800[1+0.03(1-0.23)]

The proceeds to the investor when the firm pays a dividend will be:

Proceeds of firm investments first = (1-x)$1800[1+0.03(1-0.23)]

To be indifferent, the investor’s proceeds must be the same whether she invests the aftertax dividend or receives the proceeds from the firm’s investment and pays taxes on that amount.

To find the rate at which the investor would be indifferent, we can set the two equations equal, and solve for x. Doing so, we find

$1800(1-x)[1+0.03(1-x)] = (1-x)$1800[1+0.03(1-0.23)]

1+0.03(1-x) = 1+0.03(1-0.23)

= 0.23 or 23%

b) Yes, this is a reasonable answer. She is only indifferent if the after tax proceeds from the $1,800 investment in identical securities are identical. That occurs only when the tax rates are identical.

c) Calculation of the Personal Tax Rate:

Since both investors will receive the same pre-tax return, you would expect the same answer as in part a. Yet, because Carlson enjoys a tax benefit from investing in stock.

The tax rate on ordinary income which induces indifference, is much lower. Again, set the two equations equal and solve for x:

$1800(1-x)[1+0.06(1-x)] = (1-x)($1800+(1+0.06)[0.50+(1-0.5)(1-0.23)])

1+0.06(1-x) = 1+0.06[0.50+(1-0.50)(1-0.23)]

= x = 0.115 or 11.5%

d) Yes, it is a compelling argument, but there are legal constraints, which deter firms from investing large sums in stock of other companies.