Question

After completing its capital spending for the year, Carlson Manufacturing has $1,700 extra cash. Carlson’s managers 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 22 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

   

b.	Is the answer to (a) reasonable?
	Yes No

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? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

   

d.	Is this a compelling argument for a low dividend-payout ratio?
	Yes No

Answer 1

a). Let the personal tax rate be x. If the company invests in Treasury bonds yielding 3% with corporate tax rate of 22% then the company will earn 1,700*(1 + 3%*(1-22%))

This is then paid out (in the form of dividend) to the investor who gets (1-x)*[1,700*(1 + 3%*(1-22%))] ---- (a)

If dividends are paid out directly, the investor receives 1,700*(1-x). The investor invests this in 3% Treasury bonds and earns

1,700*(1-x)*[1 + 3%*(1-x)] ---- (b)

For the investor to be indifferent between both choices,

(a) = (b)

(1-x)*[1,700*(1 + 3%*(1-22%))] = 1,700*(1-x)*[1 + 3%*(1-x)]

1 + 3% - (3%*22%) = 1 + 3% - 3%x

x = 22%

The personal tax rate has to be 22% for the investor to be indifferent between both choices.

b). It is a reasonable answer because cash flows from both choices has to be same for the investor to be indifferent between the choices. This happens when the personal tax rate = corporate tax rate.

c). 50% exclusion principle means that 50% of the preferred stock dividends are tax-exempt.

So, if the investor gets the dividends directly and he invests in the preferred stock, then his earnings will be

1,700*(1-x)*[1 + 6%*(1-x)] ---- (c)

If the company invests in preferred stock and then pays out the earnings in the form of dividends, the investor gets

1,700*(1 + 6%*(50% + (1-50%)*(1-22%))))*(1-x) ----- (d)

(c) = (d)

1,700*(1-x)*[1 + 6%*(1-x)] = 1,700*(1 + 6%*(50% + (1-50%)*(1-22%))))*(1-x)

1 + 6% - 6%x = 1+ (6%*50%) + 6%*50%*(1-22%)

x = 11.00%

d). Yes, financially it makes sense but legally, firms cannot invest very large amounts in other companies' stocks.