Question

National Business Machine Co. (NBM) has $5.5 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 3.3 percent or a 5.7 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 25 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 $5.5 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 $5.5 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

Extra cash			$      5,500,000
Period for investment			3
Treasury bill yield			3.30%
Preferred stock yield			5.70%
Dividend exclusion rate			50%
Corporate tax rate			25%
Individual dividend tax rate			20%
Individual income tax rate			33%
Solution:
If the company invests the money now:
Corporate investment in T-bills:
Aftertax T-bill yield	Treasury Bill Yield ( 1 - Tax Rate )	3.3 ( 1 - 25% )	2.48%
FV of investment	Extra Cash ( 1 + After tax t-bill yield % ) ^ 3	5,500,000 ( 1 + 2.48 % ) ^ 3=	$ 5,918,565.67
Aftertax cash flow
to shareholders	FV of Investment ( 1- Individual dividend rate tax )	5918565.67*(1-20%)=	$ 4,734,852.53
Corporate investment in preferred stock:
Preferred stock dividends	5,500,000 * Preferred stock yield = 5,500,000 * 5.7%=		$    313,500.00
Divdends excluded from tax	Preferred Stock dividend * Dividend Exclusion Tax = 313,500 * 50%=		$    156,750.00
Taxable dividends	Preferred Stock dividend Dividend Excluded from tax		$    156,750.00
Tax on preferred dividends	Taxable Dividend * Corporate Tax Rate= 156,750* 25%=		$      39,187.50
Aftertax corporate dividend	Preferred Stock Dividend - Tax on Preferred Dividend= 313,500 - 39,187.5=		$    274,312.50
Aftertax preferred
dividend yield	After tax corporate dividend / Extra Cash = 274,312.50/ 5,500,000=		4.99%
FV of preferred investment	Extra Cash ( 1 + After tax preferred dividend yield % ) ^ 3=	5,500,000 ( 1 + 4.99 % ) ^ 3	$ 6,364,663.86
Aftertax cash flow
to shareholders	FV of Preferred Investment ( 1- Individual dividend rate tax )	6,364,663.86*(1-20%)=	$ 5,091,731.09
If the company pays a dividend now:
Aftertax payment to
shareholders	Extra Cash ( 1 - Dividend Tax Rate )= 5,500,000 ( 1- 20% )=		$ 4,400,000.00
Individual invests in Treasury bills:
Aftertax individual yield
on T-bills	Treasury Bill Yield ( 1 - Tax Rate )	3.3 % ( 1 - 33%)	2.21%
FV of T-bill investment	Aftertax payment to shareholders ( 1 + After tax t-bill yield % ) ^ 3	4,400,000 ( 1 + 2.21 % ) ^ 3	$ 4,698,352.41
Individual invests in preferred stock:
Preferred stock dividends	After tax payment to Shareholders * Preferred Stock Yield=	4,400,000*5.7%	$    250,800.00
Tax on preferred dividends	Taxable Dividend * Corporate Tax Rate= 250,800* 25%=		$      82,764.00
Aftertax preferred dividend	Preferred Stock Dividend - Tax on Preferred Dividend= 250,800 - 82,764		$    168,036.00
Aftertax preferred
dividend yield	After tax preferred dividend / Aftertax payment to shareholders= 274,312.50/ 5,500,000=		3.82%
FV of preferred investment	Aftertax payment to shareholders ( 1 + After tax preferred dividend yield % ) ^ 3	4,400,000 ( 1 + 3.82 % ) ^ 3	$ 4,923,604.96