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 either Treasury bills yielding 2 percent or a 4 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 38 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 20 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, e.g. 1,234,567. Do not round intermediate calculations and round your 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, e.g. 1,234,567. Do not round intermediate calculations and round your 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, e.g. 1,234,567. Do not round intermediate calculations and round your 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, e.g. 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Value in three years

Answer 1

Part (1)

Post tax yield on t bills = 2% x (1 - tax rate) = 2% x (1 - 38%) = 1.24%

Further the returns will be paid out to the shareholders as dividend which will be taxed at the rate of 20% in the hands of shareholders.

Hence, the value after three years = Amount x (1 + post tax yield)ⁿ x (1 - personal dividend tax rate) = 3,000,000 x (1 + 1.24%)³ x (1 - 20%) =  2,490,391.65

Part (2)

If invested in preferred stock, post tax yield = Dividend rate x (1 - (1 - non taxable part of dividend) x corporate tax rate)

= 4% x (1 - (1 - 70%) x 38%) = 3.544%

Hence, the value after three years = Amount x (1 + post tax yield)ⁿ x (1 - personal dividend tax rate) = 3,000,000 x (1 + 3.544%)³ x (1 - 20%) =   2,664,317.98

Part (3)

Post tax dividend received by the shareholders = 3,000,000 x (1 - personal dividend tax rate) = 3,000,000 x (1 - 20%) = 2,400,000

Post tax yield on T bills for shareholders = 2% x (1 - per income tax rate) = 2% x (1 - 31%) = 1.38%

Hence, the value after three years = Amount x (1 + post tax yield)ⁿ = 2,400,000 x (1 + 1.38%)³ =  2,500,737.48

Part (4)

If invested in preferred stock, post tax yield = Dividend rate x (1 - x personal income tax rate)= 4% x (1 - 31%) = 2.76%

Hence, the value after three years = Amount x (1 + post tax yield)ⁿ = 2,400,000 x (1 + 2.76%)³ =    2,604,255.13