National Business Machine Co. (NBM) has $5 million of extra cash after taxes hav
ID: 2647190 • Letter: N
Question
National Business Machine Co. (NBM) has $5 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 4 percent or a 6 percent preferred stock. IRS regulations allow the company to exclude from taxable income 70 percent of the dividends received from investing in another company
National Business Machine Co. (NBM) has $5 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 4 percent or a 6 percent preferred stock. IRS regulations allow the company to exclude from taxable income 70 percent of the dividends received from investing in another company
Explanation / Answer
1. Option A : If the Company invest in T-Bill:
Total Return = 5,624,320 - 5,000,000 = $624,320
Tax on Return = 624,320 x 35% = $218,512
Income after Tax = 624,320 - 218,512 = $405,808
So, Total Value after Three Years = $5,405,808
Option B: If Company Invest in Preference Stock:
Total Dividend Income = $955,080
Tax Free Income = 955,080 x 70% = $668,556
Taxable Income = 955,080 - 668,556 = $286,524
After Tax Income = 668,556 + 286,524 (1 - .35) = $854,796.60
Total Value in Three Years = $5,854,796.60
2. If Company Pay Dividend to Common stockholder, than there will be a Tax @10%
After Tax Value of Dividend = $5,000,000 x .90 = $4,500,000
Option A : If Stockholders Invest in T-Bill :
Interest Income = $5,061,888 - 4,500,000 = $561,888
Tax on Interest Income = 561,888 x 30% = $168,566.40
After Tax Interest = 561,888 - 168,566.40 = $393,321.60
After Tax Value of Investment: 4,500,000 + 393,321.60 = $4,893,321.60
Option B: If Stockholder invest in Preferred Stock:
Dividend Income = 5,359,572 - 4,500,000 = $859,572
After Tax Income = 859,572 x (1-.30) = $601,700.40
Total Value of Investment = $4,500,000 + 601,700.40 = $5,101,700.40
Year Investment Interest Rate Interest Year end Investment 1 5,000,000 4% 200,000 5,200,000 2 5,200,000 4% 208,000 5,408,000 3 5,408,000 4% 216,320 5,624,320Related Questions
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