National Business Machine Co. (NBM) has $4 million of extra cash after taxes hav

Question

National Business Machine Co. (NBM) has $4 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’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 40 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 $4 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 $4 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 $4 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’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 40 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

It is assumed that the intervening cash flows can be invested at the same rate as the original investment; ie: compounding is applied after considering the tax incidence.

a) Total after-tax cash flow to shareholders if the company invests in T-bills:

After tax rate of return from TB to the company = 4% * (1 - tax rate) = 4 * 0.6 = 2.4%

The investment of the company will grow to 4000000*1.024^3

Cash flow to shareholders (after meeting their tax liability on corporate dividends) at the end of the 3rd year will be = 4000000*1.024^3*0.8 = $4,294,967*0.8 = $3,435,974

b) Total aftertax cash flow to shareholders if the company invests in preferred stock:

After tax rate of return from investment in preferred stock = 6% - (6%*0.3*0.4) = 5.28%

The investment of the company will grow to 4000000*1.0528^3 in three years

Cash flow to shareholders after their tax liability on dividends = 4000000*1.0528^3*0.8 = $4667643*0.8 = $3,734,114

c) The total aftertax cash flow to shareholders if the shareholder invests in T-bills:

If the company pays dividends now, the shareholders will now get $3,200,000 after paying 20% tax on dividend income (4000000*0.80)

Their after tax rate of return from TB = 4*0.69 = 2.76%

So, the amount that the investor will have at the end of three years = 3200000*1.0276^3 = $3,472,340

d) The total aftertax cash flow to shareholders if the shareholder invests in preferred stock:

If the company pays dividends now, the shareholders will now get $3,200,000 after paying 20% tax on dividend income (4000000*0.80)

Their after tax rate of return from preferred stock = 6*0.69 = 4.14%

So, the amount that the investor will have at the end of three years = 3200000*1.0414^3 = $3,614,121

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