Question

After completing its capital spending for the year, Carlson Manufacturing has $1,700 extra cash. The company’s managers must choose between investing the cash in Treasury bonds that yield 6 percent or paying the cash out to investors who would invest in the bonds themselves.

  

a.	If the corporate tax rate is 36 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let the company invest the money? (Do not round intermediate calculations. Enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

  

Personal tax rate

%

  

b.	Is the answer to (a) reasonable?
	Yes No

  

c.

Suppose the only investment choice is a preferred stock that yields 7 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of the company’s dividend decision? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Personal tax rate

%

    

d.	Is this a compelling argument for a low dividend payout ratio?
	Yes No

Answer 1

a.

Calculate the after tax cash flow from the investment made by individual investors:

Let x be the personal tax rate.

After tax cash flow = Investment * Personal tax rate * (1 + Yield * Personal tax rate)

= $1,700 * (1-x) * (1+0.06*(1-x)) ........................... (1)

Calculate the after tax cash flow from the investment made by the company:

After tax cash flow = Investment * Personal tax rate * (1 + Yield * Corporate tax rate)

= $1,700 * (1-x) * (1+0.06*(1-0.36)) ...................... (2)

Calculate the personal tax by equalizing (1) and (2) equations:

$1,700 * (1-x) * (1+0.06*(1-x)) = $1,700 * (1-x) * (1+0.06*(1-0.36))

1700(1-x) * (1.06 - 0.06x) = 1700(1-x)*1.0384

1.06 - 0.06x = 1.0384

x = 0.36 or 36%

b.

Calculate the after tax cash flow from the investment made by individual investors:

Let x be the personal tax rate.

After tax cash flow = Investment * Personal tax rate * (1 + Yield * Personal tax rate)

= $1,700 * (1-x) * (1+0.07*(1-x)) ........................... (1)

  

Calculate the after tax cash flow from the investment made by the company:

After tax cash flow = Investment * Personal tax rate * (1 + Yield * Corporate tax rate)

= $1,700 * (1-x) * [1+0.07*(0.70 + (1-0.70)*(1-0.36))] ...................... (2)

Calculate the personal tax by equalizing (1) and (2) equations:

$1,700 * (1-x) * (1+0.07*(1-x)) = $1,700 * (1-x) * [1+0.07*(0.70 + (1-0.70)*(1-0.36))]

1700(1-x) * (1.07 - 0.07x) = 1700(1-x)*1.06244

1.07 - 0.07x = 1.06244

x = 0.1080 or 10.80%