National Business Machine Co. (NBM) has $3 million of extra cash after taxes hav

Question

National Business Machine Co. (NBM) has $3 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 35 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 Suppose the company reinvests the $3 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 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 Suppose instead that the company pays a $3 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)) 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, 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

Explanation / Answer

The company has $3 million of extra cash after taxes, if the company invests in an financial assets and reinvest the cash and pays dividend in 3 yrs the total aftertax cashflow to shareholders would be if company invests in treasury bills would be as follows:

The return on treasury bills is 3% and corporate tax is 35% so after tax return would be = 0.03(1-0.35) = 1.95%

Investment income would be $3000000*((1+0.0195)^3) = $ 3178944.50

Hence the aftertax cashflow to the shareholders would be $3178944.50

If the company invests in preferred stock the after tax cashflow to shareholders would be as follows

Return from preferred stock = 5%

The corporate tax is 35% and there is personal income tax of 31% of preferred stock dividends

Hence rate of return after above tax would be = 5%*(1-0.35*0.31) =5%*(1-0.1085)=4.4575%

After tax yield to shareholders would be $3000000*0.044575*3 = $401175

The aftertax cashflow for shareholders would be $3000000+$401175 = $3401175

If the company pays dividend now and the shareholders invest in treasury bills than the aftertax cashflow for shareholders would be as follows:

Dividend paid by company is $3000000 and personal income tax on common stock dividends is 15%, the fund available for shareholders to invest in treasury bills would be $3000000*(1-0.15) = $2550000

The afertax return on treasury bills is 3%*(1-0.31) = 0.0207

Aftertax cashflow would be $2550000*(1+0.0207)^3 = $2711655.57

If the shareholders invest in preferred stock than the aftertax return would be 0.05*(1-0.31) = 0.0345

The funds available for investment with shareholder is $2550000 as computed above

The yield for shareholders would be $2550000*0.0345*3 = $ 263925

The after tax cashflow would be 2550000+263925 = $2813925

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