P.S. PLEASE DONT COPY ANSWERS OF OTHERS, THEY ARE INCORRECT National Business Ma
ID: 2612996 • Letter: P
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P.S. PLEASE DONT COPY ANSWERS OF OTHERS, THEY ARE INCORRECT
National Business Machine Co. (NBM) has $6 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 30 percent Personal income tax rate, which is applied to interest income and preferred stock dividends. The Personal dividend tax rate is 10 percent on common stock dividends.Explanation / Answer
After tax interest yield = interest rate x( 1- tax rate)
= 3% x ( 1- 0.35)
= 1.95%
Value after three years = investment x (1+after tax return)^n
=6,000,000 x (1+0.0195)^3
=6357888.99
This will be paid as dividend and dividend tax rate is 10%. Therefore,
After tax outflow to shareholders = 6357888.99 x(1-0.10)
= 5,722,100.09
2. Preferred stock pays 5% dividend. Therefore, dividend received from investing in preferred stock:
Dividend received = 6,000,000 x 5%
= 300,000
Now 70% of this dividend is tax free so only 30% is taxable. Therefore tax charged on dividend would be:
Tax charged = 300,000 x30% x 35%
= 31,500
After tax preferred dividend = = dividend received – taxes paid
= 300,000-31500
= 268,500
After tax dividend yield = 268,500/6,000,000
=4.475%
Future value of investment = investment x (1+after tax return)^n
=6,000,000 x (1+0.0475)^3
=6,896,255.53
This will be paid as dividend and dividend tax rate is 10%. Therefore,
After tax outflow to shareholders = 6,896,255.53x (1-0.10)
= 6206629.98
3.Investor will 10% as personal dividend tax. So net amount received by investor is
Net amount received = total dividend x (1- tax rate)
= 6,000,000 x (1-0.10)
=5,400,000
So he will invest 5,400,000.
Now they invest in t bills and they have to pay 30% taxes. Therefore after tax return from t bill would be:
After tax interest yield = interest rate x( 1- tax rate)
= 3% x ( 1- 0.3)
= 2.1%
Value after three years = investment x (1+after tax return)^n
=5,400,000 x (1+0.021)^3
=5,747,394.21
4. Now they invest in preferred stock and they have to pay 30% taxes on the 30% return generated. Therefore after tax return from preferred stock would be:
After tax interest yield = dividend rate – proportion to tax payable interest rate x( 1- tax rate)
= 5% - 0.30 x 5% x ( 1- 0.3)
= 3.95%
Value after three years = investment x (1+after tax return)^n
=5,400,000 x (1+0.0395)^3
=6,065,508.85
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