Question

National Business Machine Co. (NBM) has $9 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 percent or a 5 percent preferred stock. IRS regulations allow the company to exclude from taxable income 70 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 35 percent. Assume the investor has a 31 percent personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 10 percent on common stock dividends.

Suppose the company reinvests the $9 million and pays a dividend in three years.

What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value in three years

$

What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value in three years

$

Suppose instead that the company pays a $9 million dividend now and the shareholder reinvests the dividend for three years.

What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value in three years

$

What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Value in three years

$

Answer 1

Solution:

a)
If the firm invests in T-bills, the aftertax yield of the T-bills will be:
After tax corporate yield = 3%(1 – .35)	1.95%
FV of investment in T-bills = $9,000,000 x FV(1.95%,3)	$9,536,833.48
The future value will be paid to shareholders as a dividend, the aftertax cash flow will be
Aftertax cash flow to shareholders = $9,536,833.48 x (1 - 10%)	$8,583,150.14
Value in three years	$8,583,150.14
b)
If the firm invests in preferred stock:
Preferred Dividend = $9,000,000 x 5%	$450,000
Taxable preferred dividends = (1 – .70)($270,000)	$135,000
Taxes on preferred dividends = 35% x $81,000	$47,250
Aftertax corporate dividend = $270,000 - $28,350	$402,750
Aftertax corporate dividend yield = $241,650/$9,000,000	4.47%
FV of investment in Preferred = $9,000,000 x FV(4.47%,3)	$10,263,125.72
Aftertax cash flow to shareholders = $9,744,589.12 x (1 - 10%)	$9,236,813.15
Value in three years	$9,236,813.15