National Business Machine Co. (NBM) has $9 million of extra cash after taxes hav

Question

National Business Machine Co. (NBM) has $9 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 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 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 20 percent on common stock dividends.

Suppose the company reinvests the $9 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))

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))

Suppose instead that the company pays a $9 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))

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))

National Business Machine Co. (NBM) has $9 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 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 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 20 percent on common stock dividends.

Explanation / Answer

Ans;

a)

If the firm invests in T-Bills:

After tax corporate yield = 0.02 (1-0.35) = 0.013 or 1.3%

For 3 years = 2.9236

Future value of investment in T- Bills = $9000000 * 2.9236 = $ 26312918.71

After tax cash flow to shareholders = $ 26312918.71 (1 - 0.15) = $ 22365980.9

If the firm invests in Preferred stock:

Taxable preferred dividend = $9000000 * 70% = $6300000

Taxes on preferred dividend = $6300000 * 35% = $2205000

After tax preferred dividend = $6300000- $ 2205000 = $4095000

After tax dividend yield = $4095000/$9000000 = 0.455

For 3 years = (1+ 0.455) for 3 years = 1.48429

Future value in preferred stock = $ 9000000 * 1.48429 = $13358636

After cash flow to shareholders = $ 13358636 * (1-0.15) = $11354840.85

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