Question

National Business Machine Co. (NBM) has $4.9 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 3% or 5% preferred stock. IRS regulations allow the company to exclude from taxable income 70% 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 21%. Assume the investor has a 31% personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 15% on common stock dividends.

• Should the cash be paid today or in three years?
• Which of the two options generates the highest after-tax income for the shareholders?

Answer 1

Which option is best

The treasury bill pays 3% and there is no tax benefit on such income

On the other hand the investment in preferred stock generate the income of of 5%. Add to that there is 70% tax deduction on dividend from preferred stock.

Hence it is beneficial how to invest in 5% preferred stocks (even before tax exemption prefered stocks are better).

should cash be paid today or after 3 years

  Option 1-Cash paid after 3 years

The company will invest in 5% preferred stock (explained above)

Dividend income in the hands of company =4.9 millions *.05= $0.245 millions

Tax on 30% income. (70% is exepmt) =0.245m*0.3*0.21= $0.015435 millions

Net income after tax. =$0.245m-$0.015435 m

=$0.229565 millions

This income is distributed to share holders as dividend on which they pay income tax @15%

Income received by shareholders =$0.229565

Income tax paid by shareholder =$0.229565*0.15=0.03443475 million

Net income for shareholders = 0.229565m-$0.034434750m

=$0.19513025million

If the cash is paid at years 0

Share holders will invest in 5% prefered stock

Income received by shareholders = $4.9 m*0.05= $0.245millions

Income tax paid @31% (there is no tax deduction to shareholders)=0.245m*0.31=$0.07595 millions

Net income for shareholders =$0.16905 millions

Since net income in option 1 is higher,the company should pay cash after 3 years as it result in higher cashflow to shareholders.