Question

1. KMS Corporation faces a choice between

• paying out $200 million cash through a share repurchase, and
• investing the $200 million in Treasury securities paying 5% interest for one year.

If shareholders are paid the cash through a share repurchase they are going to invest it in the same T-securities as KMS would. If KMS retains and invests cash it is going to pay the entire investment income out to shareholders in the form of dividends

Assume that corporate tax rate is 40% and investors pay 15% tax rate on dividends and capital gains and 30% on interest income. What would shareholders want KMS to do with the cash? Explain, provide computations

Answer 1

Solution:

Alt 1) $ 200 mn Share repurchase and investors will invest cash in T-securities.

As we don't have the purchase value of shares for investors we can assume the whole $200mn as capital gains for decision purpose. So

Cash received from company = $ 200

Less: capital gains tax @15%= $ 30

The amount available for investment in hands of investors =$170 mn

The investor will invest this amount @ 5% in T-Securities.Tax rate on interest income = 30%.So after-tax rate of interest is (0.05*0.7) = 0.035

Cash flow after tax in 1 year

= 170 * (1+i)

= 170 * 1.035 =$ 175.95 mn

b) $ 200mn company should directly invest in T-Securities @ 5% p.a & distribute to shareholders in the form of a dividend. Corporate tax rate = 40%,.So after-tax rate of interest is (0.05*0.6) = 0.03

Cash flow after tax in the hands of the company after 1 year = (200 * 1.03)

= $ 206mn

Then it will distribute this $ 206mn to shareholders as a dividend. Tax on the dividend is 15%

Cash flow after tax in hands of investors = 206 * 0.85 = $ 175.1 mn

As Alternative of giving cash to investors by share repurchase results in higher cash flow in their hands.

So Shareholders want KMS to exercise the option of paying out $ 200mn cash through share repurchase.