Question

National Business Machine Co. (NBM) has $5.4 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 3.2 percent or a 5.6 percent preferred stock. IRS regulations allow the company to exclude from taxable income 50 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 24 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 $5.4 million and pays a dividend in three years.
a-1.	What is the total aftertax cash flow to shareholders if the company invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)
a-2.	What is the total aftertax cash flow to shareholders if the company invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Suppose instead that the company pays a $5.4 million dividend now and the shareholder reinvests the dividend for three years.
b-1.	What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)
b-2.	What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Please show answers with detailed calculations.

Answer 1

a-1). Company invests in T-bills for 3 years:

Amount after 3 years = amount invested*(1+ after-tax yield)^3 = 5,400,000*(1 + (3%*(1-24%))^3 = 5,803,643.37

After-tax cash flow to share holders = 5,803,643*(1-personal income tax rate) = 5,803,643.37*(1-15%) = 4,933,096.86

a-2). Company invests in preferred stock for 3 years:

After-tax return on preferred stock = (preferred stock yield*dividend exclusion rate) + ((preferred stock yield*(1-dividend exclusion rate)*(1- corporate tax rate)) = (5.6%*50%) + (5.6%*(1-50%)*(1-24%)) = 4.928%

Amount after 3 years = amount invested*(1+ after-tax yield)^3 = 5,400,000*(1+4.928%)^3 = 6,238,324.26

After-tax cash flow to shareholders = 6,238,324.26*(1-personal income tax rate) = 6,238,324.26*(1-15%) = 5,302,575.62

b-2). After-tax cash given to shareholders = 5,400,000*(1 - personal income tax rate) = 5,400,000*(1-15%) = 4,590,000

After-tax yield on T-bills = yield*(1-personal tax rate on interest income) = 3%*(1-31%) = 2.208%

After-tax cash flow to shareholders after 3 years = amount invested*(1+after-tax yield)^3

= 4,590,000*(1+2.208%)^3 = 4,900,804.25

b-2). After-tax cash flow to shareholders = 4,590,000

After-tax yield on preferred stocks = yield*(1-personal tax rate on preferred stock dividends) = 5.6%*(1-31%) = 3.864%

After-tax cash flow to shareholders after 3 years = amount invested*(1+after-tax yield)^3

= 4,590,000*(1+3.864%)^3 = 5,142,896.90