A corporation has $1,200,000 in cash on its balance sheet that could be used to

ID: 2793123 • Letter: A

Question

A corporation has $1,200,000 in cash on its balance sheet that could be used to pay a special dividend of $5 per share.

One of the financial managers of the corporation says that a repurchase of shares using that $1,200,000 would be a better idea

because the corporation's investors would save $384,000 in taxes for that tax year (as compared to the special dividend).

The manager assumes the dividend tax rate is 40% and the capital gains tax rate is 20%. The manager also assumes

that the investors who would sell shares the corporation repurchases bought their shares at an average price of $30 per share.

What must be the price of the corporation's stock that will be paid to repurchase shares that the manager assumed

in calculating the $384,000 tax savings?

$40

$50

$60

$20

$40

$50

$60

$20

Answer:

the net tax saving would be the difference between the tax paid on dividend minus the tax paid on the capital gain on share buyback

lets say the share price of the buy back is $X

1200000/X is the number of shares bought back

X-30 is the capital gain on each share

1200000* 40% - ((1200000)/X)*(X-30)*20% = 384000

On solving this

96000 = 1200000*0.2 * (X-30)/X

0.4*X = X- 30

0.6*X = 30

X = $50

Option B is the answer

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