Question

National Business Machine Co. (NBM) has $6 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 Treasury bills yielding 3.8 percent or a 6.2 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 38 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 $6 million and pays a dividend in three years.

What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Do not round intermediate calculations and enter you answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Do not round intermediate calculations and enter you answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

Suppose instead that the company pays a $6 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? (Do not round intermediate calculations and enter you answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Do not round intermediate calculations and enter you answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

Answer:

1) After-tax return on T-bills = 3.8% * (1-25%) = 0.0285 = 2.85%

Amount after 3 years will be 6,000,000 * (1+2.85%) ^3 = $6,527,759.39

Shareholders will get after-tax amount of 6,527,759.39 *(1-10%) = $5,874,983.451

2) After-tax return = 6.2% * [dividend exclusion ratio + (1- exclusion ratio) * (1-corporate tax rate)]

= 6.2% * [50% + (1-50%) * (1-25%)] = 0.05425 = 5.425%

3-year return will be 6,000,000*(1+5.425%) ^3 = $7,030,433.09

Shareholders will receive after-tax amount of 7,030,433.09*(1-10%) = $6,327,389.78

3) If company pays out $6 million as dividends then shareholders will receive

6,000,000 * (1-10%) = $5,400,000

After-tax return for the shareholders will be 3%*(1-38%) = 0.0186 = 1.86%

After 3 years, shareholders receive an after-tax amount of 5,400,000*(1+1.86%)^3 = $5,706,959.30

4) After-tax return on preferred stock for shareholders = 6.2%*(1-38%) = 3.844%

After 3 years, shareholders receive an after-tax amount of 5,400,000*(1+3.844%)^3 = $6,046,972.38

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