National Business Machine Co. (NBM) has $5 million of extra cash after taxes hav

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 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 36 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.

Please correct the all answers.

Suppose the company reinvests the $5 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)) Value in three years 288000 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)) Value in three years 669000 Suppose instead that the company pays a $5 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.( Value in three years 248400 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) Value in three years 414000

Explanation / Answer

Solution.

1. Calculation for after tax cash flow to shareholder if invest in T-bills.

After tax interest...
5m* [0.03 * 3) * (1 - 0.36]
= $288,000
And add the $5m for 5,288,000 to shareholders
Then shareholders pay taxes on those dividends and end up with : 5,288,000 (0.80) = 4,230,400
(where 0.80 = 1 - tx rate on "personal" dividends)

2. What is the total aftertax cash flow to shareholders if the company invests in preferred stock?

preferred dividends:
= 5m * [0.05 * 3]
= $750,000
Taxes: $750,000 (0.30)(0.36) = $81,000
Net to shareholders: 5m + 750,000 - 81,000 = $5,669,600
then shareholders pay taxes on those dividends and end up with: $5,669,600 (0.80) = $4,535,200

3. What is the total aftertax cash flow to shareholders if the shareholder invests in T-bills?

Net after taxes on the original 9m dividend paid:
5m ( 1 - 0.20) = 4,000,000
Interest on T-bills:4,000,000 (0.03 * 3) = 360,000
Interest net of taxes = 360,000 (1 - 0.31) = 248,400
Net after tax : 4,000,000 + 248,400 = $4,248,400.

4. What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock?

After tax dividends from the $5m ( 1 - .20 ) = 4m
Preferred divs net of taxes: 4 m ( 0.05 * 3) (1 - 0.31) = $414,000
Total: 4,000,000 + $414,000 = $4,414,000

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