National Business Machine Co. (NBM) has $7 million of extra cash after taxes hav
ID: 2801032 • Letter: N
Question
National Business Machine Co. (NBM) has $7 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 speci 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 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 15 percent on common stock dividends al dividend at the end of three years. In this case, the firm can corporate tax rate is 38 Suppose the company reinvests the $7 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, e.g., 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 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, e.g., 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 Suppose instead that the company pays a $7 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, e.g., 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 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, e.g., 1,234,567. Do not round intermediate calculations and round your final answer to 2 decimal places, e.g., 32.16.) Value in three yearsExplanation / Answer
Given -
Cash after taxes - $7 million
Treasury Bill yield rate - 3%
Preferred stock rate - 5%
IRS regulations allow the company to exclude from taxable income 70 percent of the dividends received from investing in another company’s stock.
Corporate tax rate - 38%
Personal income tax rate - 31%
Personal dividend tax rate - 15%
Assumption -
Let us assume that thecash flows can be invested at the same rate as the original investment (calculation will be inclusive of tax amount)
A) To Find - total aftertax cash flow to shareholders, if the company invests in T-bills
Calculation -
Rate on Treasury Bill after tax will be as under -
= 3 x (1 - corporate tax rate)
= 3 x (1 - 0.38)
= 3 x 0.62
= 1.86%
Rate on Treasury Bill after tax = 1.86%
So, investment of the company after 3 years will be as under -
= $7,000,000*(1 + 0.0186)*3 years
= $7,000,000*(1.0186)*3 years
= $21,390,600
Investment of the company after 3 years = $21,390,600
Total aftertax (after paying corporate dividend tax) cash flow to shareholders, if the company invests in T-bills in the end of 3rd year will be as under -
= $7,000,000*1.0186*3*(1- 0.15)
= $7,000,000*1.0186*3*0.85
= $18,182,010
Total aftertax cash flow to shareholders, if the company invests in T-bills in the end of 3rd year = $18,182,010
B) To Find - Total aftertax cash flow to shareholders, if the company invests in preferred stock
Calculation -
Rate on preferred stock after tax will be as under -
= 5 - [5*(1 - 0.70)*(1 - corporate tax rate)]
= 5 - [5*(0.30)*(1 - 0.38)]
= 5 - [5*(0.30)*(0.62)]
= 5 - 0.93
= 4.07%
Rate on preferred stock after tax = 4.07%
So, investment of the company after 3 years will be as under -
= $7,000,000*(1 + 0.0407)*3 years
= $7,000,000*(1.0407)*3 years
= $21,854,700
Investment of the company after 3 years = $21,854,700
Total aftertax (after paying corporate dividend tax) cash flow to shareholders, if the company invests in preferred stock in the end of 3rd year will be as under -
= $7,000,000*1.0407*3*(1- 0.15)
= $7,000,000*1.0407*3*0.85
= $18,576,495
Total aftertax cash flow to shareholders, if the company invests in preferred stock in the end of 3rd year = $18,576,495
C) To Find - total aftertax cash flow to shareholders, if the shareholders invests in T-bills
If the company pays dividends now, the shareholders will now get $5,950,000 (7,000,000*0.85) after paying15% tax on dividend income.
Calculation -
Rate on Treasury Bill after tax will be as under -
= 3 x (1 - individual tax rate)
= 3 x (1 - 0.31)
= 3 x 0.69
= 2.07%
Rate on Treasury Bill after tax = 2.07%
Total aftertax (after paying corporate dividend tax) cash flow to shareholders, if the shareholders invests in T-bills after 3 years will be as under -
= $5,950,000*(1 + 0.0207)*3 years
= $5,950,000*(1.0207)*3 years
= $18,219,495
Total aftertax cash flow to shareholders, if the shareholders invests in T-bills after 3 years = $18,219,495
D) To Find - Total aftertax cash flow to shareholders, if the shareholders invests in preferred stock
Calculation -
Rate on preferred stock after tax will be as under -
= 5 - [5*(1 - 0.70)*(1 - individual tax rate)]
= 5 - [5*(0.30)*(1 - 0.31)]
= 5 - [5*(0.30)*(0.69)]
= 5 - 1.035
= 3.965
= 3.97% (rounded off to 2 decimal places)
Rate on preferred stock after tax = 3.97%
Total aftertax (after paying corporate dividend tax) cash flow to shareholders, if the shareholders invests in preferred stock after 3 years will be as under -
= $5,950,000*(1 + 0.0397)*3 years
= $5,950,000*(1.0397)*3 years
= $18,558,645
Total aftertax cash flow to shareholders, if the shareholders invests in preferred stock after 3 years = $18,558,645
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