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.

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?

Value in three years $_______

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

Value in three years $_______

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?

Value in three years $______

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

Value in three years $______

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.

Explanation / Answer

Answer 1 (1) Extra Cash available 5000000 Treasury Bill Yield @ 3% p.a. 150000 less Tax @ 36% 54000 Yearly Yield 96000 Total Cash flow after tax in 3 years 288000 Answer 1 (2) Extra Cash available 5000000 Preferred Stock @ 5% 250000 less Tax @ 36% on 30% income 27000 Yearly Yield 223000 Total Cash flow after tax in 3 years 669000 Answer 2 (1) Extra Cash available 5000000 If distributed to share holder and the invest in Dividend distributed tax @ 20% 1000000 Cash available in hand of share Holders to invest 4000000 Treasury Bill Yield @ 3% p.a. 120000 less Tax @ 31% 37200 Yearly Yield 82800 Total Cash flow after tax in 3 years 248400 Answer 2 (2) Extra Cash available 5000000 If distributed to share holder and the invest in Dividend distributed tax @ 20% 1000000 Cash available in hand of share Holders to invest 4000000 Preferred Stock @ 5% 200000 less Tax @ 31% 62000 Yearly Yield 138000 Total Cash flow after tax in 3 years 414000

Related Questions

Navigate

• Browse (All)
• Browse N
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.