Question

a. After completing its capital spending for the year, HSU Manufacturing has $1,000

extra cash. HSU’s managers must choose between investing the cash in Treasurybonds that yield 8% or paying the cash out to investors who would invest in the bonds themselves.

1. If the corporate tax rate is 35%, what personal tax rate would make the investors equally willing to receive the dividend or to let HSU invest the money?

2. Is the answer to part i) reasonable? Explain.

b. The desire for high current income is a valid explanation of preference for high current

dividend policy. Comment on the validity of this statement.

Answer 1

a). Let the ordinary income tax rate be x.

After-tax dividend to the shareholders = 1,000*(1-x)

If the shareholders invest in Treasury bonds then after-tax cash flow will be 1,000*(1-x)*[1 + 8%*(1-x)]

If the firm invests in Treasury bonds then after-tax cash flow is 1,000*[1 + 8%*(1-35%)] = 1,052

After-tax cash flow for shareholders becomes = 1,052*(1-x)

For the investors to be indifferent between both options,

1,052*(1-x) = 1,000*(1-x)*[1+8%*(1-x)]

1.052 = 1 + 8% -8%x

1.052 -1.08 = -0.08x

x = 35%

If the personal tax rate is same as the corporate tax rate, investors will be indifferent between the two choices.

Yes, the answer is reasonable because the after-tax cash flows in both cases has to be same for the investors to be indifferent. This happens only when personal tax rate equals corporate tax rate.

b). In a world with no transaction costs, the desire for high current income is not a valid explanation for preferring high dividend policy because the same cash flows can be created by selling off, part of the stock held by an investor. For investors who desire a low current cash flow and already hold high paying dividend stock, they can reinvest the dividends, to achieve the same. However, in the real world, the exact cash flows cannot be recreated due to transaction costs (such as brokerage fee, etc.). Even then, given the low transaction costs provided by brokerage houses and mutual funds, more or less the same cash flows can be recreated using home-made dividends.