Question

MIDSTRATA Co. has $3 million of extra cash after taxes have been paid. It has two choices to make use of this cash. First 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% or a 5% preferred stock. CRA regulations allow the company to exclude from taxable income 100% of the dividends received from investing in another company's stock. Second 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%. Assume the investor has a 31% personal income tax rate, which is applied to interest income. The personal dividend tax rate is 15% on common stock dividends after applying the dividend tax credit.

a) Should the cash be paid today or in three years?

b) Which of the two options generates the highest after-tax income for the shareholders?

Answer 1

According to the above given question the solution as follows that the 3 million of additional money after duty is completely contributed. Along these lines, the estimation of every option is.

Elective 1 :- The firm put resources into T-charges or favored stock and afterward payout an exceptional profit following 3 years.

The firm put resources into T-bills:-

The T-charges yield = 3%

Expense after T - charges yield = 3% ( 1-0.35) =1.95 %

Future estimation of T bills = Amount contributed * (1+I)^n

Here sum contributed = 3,000,000

I = 1.95%. n= 3years

Future estimation of T bills = 3,000,000 * ( 1.0195)^3

Future estimation of T charges following 3 years = $ 3,178,944.48

The after expense incomes to investors will be = $ 3,178,944.8 * ( 1-0.15) = $ 2,702,103.08

After expense incomes to investors following 3 years. on the off chance that, firm contribute T-bills = $ 2,702,103.08

On the off chance that firm put resources into Preferred stock :-

Note :- if firm put resources into Preferred stock, The presumption would be the profit gotten in favored stock ought to be reinvested in same favored stock.

Favored profit = $ 3,000,000 * 5% = $ 150,000

CRA guidelines permit the organization to reject from assessable pay 100% of the profits got from putting resources into another organization's stock.

Favored profit yield = 5%

Future estimation of favored stock following 3 years = 3,000,000 *( 1+0.05)^3. = $ 3,472,875.

After duty incomes to investors that profit charge = $ 3,472,875 * ( 1-0.15) = $ 2,951,943.75

After duty incomes to investors , if firm put resources into favored stock = $ 2,951,943.75.

Elective 2 :- the firm deliver out profit to investors now and individual put resources into their own.

The after duty money profit got today to investors = $ 3,000,000 * (1-0.15) = $ 2,550,000.

The individual put resources into T - bills.

After expense singular T-charges yield = 3% ( 1-0.31) = 2.07%

The future estimation of individual interest in T bills = $ 2,550,000 * ( 1+ 0.0207)^3. =$ 2,711,655.57.

The future estimation of individual interest in T-bills = $ 2,711,655.57

individual put resources into favored stock :-

Note :- if firm put resources into Preferred stock, The supposition would be the profit gotten in favored stock ought to be reinvested in same favored stock.

Favored profit = $ 2,550,000* 5% = $ 127,500.

The duty on Preferred stock profit = $ 127,500 * 0.31 = $ 39,525.

After duty favored stock profit = $ 127,500 - $ 39,525 = $ 87,975.

After duty singular contributing favored stock yield = 87,975/2,550,000 = 3.45%

Future worth individual putting resources into Preferred stock = 2,550,000 * (1.0345)^3 = $ 2,823,135.12

After duty Future estimation of individual putting resources into Preferred stock = $ 2,823,135.12

In the event that organization put away the incomes contributed

In T-charges, Future worth - $ 2,702,103.08.

In favored stock, Future worth - $ 2,951,943.75

In the event that individual put resources into their own, the incomes contributed -

In T-charges, Future worth - 2,711,655.57

In favored stock, future worth - 2,823,135.12.

a)

in the event that both organization and individual are likely put to be in T-bills.

The incomes are paid currently is best optiin. That the individual put resources into their own in T-bills.

on the off chance that both organization and individual are likely put to be in favored stock-

The incomes are put resources into Preferred stock by firm is best option.That is firm in put resources into Preferred stock.

B)

The favored stock is the most noteworthy produce incomes to investors holders by contributing by firm.