After completing its capital spending for the year, Carlson manufacturing has $2

Question

After completing its capital spending for the year, Carlson manufacturing has $2600 extra cash. Carlson's managers must choose between investing the cash in Treasury Bonds that yield 6 percent or paying the cash out to investors who would invest in the bonds themselves.
A) if the corporate tax rate is 35 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money?
B) suppose only the investment choose is a preferred stock that yields 5 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of Carlson's dividend decision?

Explanation / Answer

(A)

Let x be the ordinary income tax rate. The individual receives an after-tax dividend of $2600(1-x) which she invests in Treasury bonds.  

The T-bond will generate after-tax cash flows to the investor of $2600 (1 - x)[1+0.06(1-x)].

If the firm invests the money, its proceeds are $2600 [1 + 0.06 (1-0.35)]

To be indifferent, the investor’s proceeds must be the same whether she invests the after-tax dividend or receives the proceeds from the firm’s investment and pays taxes on that amount.

Set the 2 equations equal and solve for x:

(1-x)*$2600 [1 + 0.06 (1-0.35)] = $2600 (1 - x)[1+0.06(1-x)].

x=0.35

(B)

Similarly solve second problem

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