Question

National Business Machine Co. (NBM) has $3 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 Treasury bills yielding 3 percent or a 5 percent preferred stock. IRS regulations allow the company to exclude from taxable income 70 percent 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 35 percent. Assume the investor has a 31 percent personal income tax rate, which is applied to interest income and preferred stock dividends. The personal dividend tax rate is 15 percent on common stock dividends.

Suppose the company reinvests the $3 million and pays a dividend in three years.

What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Value in three years

$

What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Value in three years

$

Suppose instead that the company pays a $3 million dividend now and the shareholder reinvests the dividend for three years.

What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Value in three years

$

What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Value in three years

$

Answer 1

Question 1:

Before-tax interest income on T-bills received by company over 3 years => $3 million * 3% * 3 years => $270,000

After-tax interest income on T-bills received by company over 3 years => before-tax income * (1 - corporate tax rate) => $270,000 * (1 - 0.35) => $175,500

After-tax cashflow to shareholders = after-tax interest income received by company * (1 - personal dividend tax rate)

After-tax cashflow to shareholders = $175,500 * (1 - 0.15) => $149,175

Question 2:

Before-tax dividend income on preferred stock received by company over 3 years => $3 million * 5% * 3 years => $450,000

Effective tax rate on preferred stock dividend = % of dividend taxable * corporate tax rate => 0.30 * 0.35 => 0.105, or 10.5%

After-tax dividend income in preferred stock received by company over 3 years = before-tax dividend * 30% * (1 - effective tax rate)

After-tax dividend income received by company = $450,000 * (1 - 0.105) => $402,750

After-tax cashflow to shareholders = after-tax dividend income received by company * (1 - personal dividend tax rate)

After-tax cashflow to shareholders = $402,750 * (1- 0.15) => $342,337.50

Question 3:

After tax-dividend received now by shareholders = before-tax dividend * (1 - personal dividend tax rate) => $3 million * (1- 0.15) => $2,550,000

Before-tax interest income on T-bills received by shareholders = $2,550,000 * 3% * 3 years => $229,500

After-tax cashflow to shareholders = before-tax interest income * (1 - personal income tax rate) =>

$229,500 * (1 - 0.31) => $158,355

Question 4:

After tax-dividend received now by shareholders = before-tax dividend * (1 - personal dividend tax rate) => $3 million * (1- 0.15) => $2,550,000

Before-tax dividend income on preferred stock received by shareholders = $2,550,000 * 5% * 3 years => $382,500

After-tax cashflow to shareholders = before-tax dividend income * (1 - personal income tax rate) => $382,500 * (1- 0.31) => $263,925