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

The 3 million of extra cash after tax is fully invested. So, the value of each alternative is.

Alternative 1 :- The firm invest in T- bills or preferred stock and then payout a special dividend after 3 years.

The firm invest in T- bills:-

The T- bills yield = 3%

Tax after T - bills yield = 3% ( 1- 0.35) =1.95 %

Future value of T bills = Amount invested * (1+I)^n

Here amount invested = 3,000,000

I = 1.95%. n= 3years

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

Future value of T bills after 3 years = $ 3,178,944.48

The after tax cash flows to shareholders will be = $ 3,178,944.8 * ( 1- 0.15) = $ 2,702,103.08

After tax cash flows to shareholders after 3 years. if, firm invest T- bills = $ 2,702,103.08

If firm invest in Preferred stock :-

Note :- if firm invest in Preferred stock, The assumption would be the dividend received in preferred stock should be reinvested in same preferred stock.

Preferred dividend = $ 3,000,000 * 5% = $ 150,000

CRA regulations allow the company to exclude from taxable income 100% of the dividends received from investing in another company's stock.

Preferred dividend yield = 5%

Future value of preferred stock after 3 years = 3,000,000 *( 1+0.05)^3. = $ 3,472,875.

After tax cash flows to shareholders that dividend tax = $ 3,472,875 * ( 1-0.15) = $ 2,951,943.75

After tax cash flows to shareholders , if firm invest in preferred stock = $ 2,951,943.75.

Alternative 2 :- the firm pay out dividend to shareholders now and individual invest in their own.

The after tax cash dividend received today to shareholders = $ 3,000,000 * (1-0.15) = $ 2,550,000.

The individual invest in T - bills.

After tax individual T- bills yield = 3% ( 1-0.31) = 2.07%

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

The future value of individual investment in T- bills = $ 2,711,655.57

individual invest in preferred stock :-

Note :- if firm invest in Preferred stock, The assumption would be the dividend received in preferred stock should be reinvested in same preferred stock.

Preferred dividend = $ 2,550,000* 5% = $ 127,500.

The tax on Preferred stock dividend = $ 127,500 * 0.31 = $ 39,525.

After tax preferred stock dividend = $ 127,500 -$ 39,525 = $ 87,975.

After tax individual investing preferred stock yield = 87,975/2,550,000 = 3.45%

Future value individual investing in Preferred stock = 2,550,000 * (1.0345)^3 = $ 2,823,135.12

After tax Future value of individual investing in Preferred stock = $ 2,823,135.12

If company invest the cash flows invested-

In T- bills, Future value - $ 2,702,103.08.   

In preferred stock, Future value - $ 2,951,943.75

If individual invest in their own, the cash flows invested -

In T- bills, Future value - 2,711,655.57

In preferred stock, future value -2,823,135.12.

a)

if both company & individual are likely invested to be in T- bills.

The cash flows are paid now is best optiin. That the individual invest in their own in T- bills.

if both company & individual are likely invested to be in preferred stock-

The cash flows are invested in Preferred stock by firm is best option.That is firm in invested in Preferred stock.

B)

The preferred stock is the highest generate cash flows to shareholders holders by investing by firm.