Question

a. After completing its capital spending for the year, U Manufacturing has $1,000 extra cash. U’s managers must choose between investing the cash in Treasury bonds that yield 8% or paying the cash out to investors who would invest in the bonds themselves.

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

ii. 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

i. 35%

the indifference between the dividend or investment happens when the personal tax rate is equal to corporate tax rate. when they are equal investor will be indifferent between dividend and Investing the money

ii. Yes the answer is reasonable

a. if lets says personal tax rate is X

After tax dividend = $1000 * (1 - X)

when the amount received as dividend is invested then after tax cash flow from investment = $1000 * (1 - X) * (1 + 0.08(1 - X))

b. if the extra cash is invested instead of dividend then proceeds = 1000 * (1 + 0.08(1 - 0.35))

when proceeds from investment is declared as dividends then after tax dividend = (1 - X) * 1000 * (1 + 0.08(1 - 0.35))

Indifference happens when both are equal

$1000 * (1 - X) * (1 + 0.08(1 - X)) = (1 - X) * 1000 * (1 + 0.08(1 - 0.35))

1 - X= 1 - 0.35

thus X = 35%

b. True. There will be transactions costs of trading in securities which makes home made dividends expensive when compared with dividends paid by firm.