Question

National Business Machine Co. (NBM) has $3 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 4 percent or a 6 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 38 percent. Assume the investor has a 30 percent personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 15 percent on common stock dividends.

Suppose the company reinvests the $3 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 $3 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

Company invests in T-bills

The company will pay a tax of 38% on the interest income from T-bills.

After - tax return to company each year for investing in T-bills = 4% x (1 - 0.38) = 2.48%

Value of Dividend payable to shareholders = Amount invested x (1 + r)ⁿ

or, Value of Dividend payable to shareholders = $3,000,000 x (1 + 0.0248)³ = $3,228,781.11897

Now, shareholders will pay a tax of 15% on the above amount.

After - tax cash flow to shareholders = $3,228,781.11897 x (1 - 0.15) = $2,744,463.95113 or $2,744,463.95

Company invests in Preferred stock

The company will pay a tax of 38% on 30% of the dividend income from preferred stock.

After - tax return to company each year for investing in Preferred stock = 6% - [ 6% x 30% x 38% ] = 5.316%

Value of Dividend payable to shareholders = $3,000,000 x (1 + 0.05316)³ = $3,504,324.55857

Now, shareholders will pay a tax of 15% on the above amount.

After - tax cash flow to shareholders = $3,504,324.55857 x (1 - 0.15) = $2,978,675.87479 or $2,978,675.87

Shareholders invest in T-bills

The shareholders will get dividend for investment = $3,000,000 - Tax @15% = $2,550,000

Shareholders will invest this amount for 3 years in T-bills

After tax return on T-bills to shareholders = 4% x (1 - 0.30) = 2.8%

After - tax cash flow to shareholders = $2,550,000 x (1 + 0.028)³ = $2,770,253.5776 or $2,770,253.58

Shareholders invest in Preferred stock

Similar to above shareholders will get $2,550,000 after tax as dividend from the company.

Shareholders will invest this amount for 3 years in preferred stock. Note that 70% tax exclusion is only in case company invests in preferred stock.

After tax return on T-bills to shareholders = 6% x (1 - 0.30) = 4.2%

After - tax cash flow to shareholders = $2,550,000 x (1 + 0.042)³ = $2,884,983.5244 or $2,884,983.52