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

Explanation / Answer

Since the $3,000,000 cash is after corporate tax, the full amount will be invested. So, the value of each alternative is:

  Alternative 1:

The firm invests in T-bills or in preferred stock, and then pays out as a special dividend in 3 years. If the firm invests in T-Bills:

If the firm invests in T-bills, the aftertax yield of the T-bills will be:

Aftertax corporate yield = .05(1 – .35)

Aftertax corporate yield = .0325 or 3.25%So, the future value of the corporate investment in T-bills will be:

FV of investment in T-bills = $3,000,000(1 + .0325)3

FV of investment in T-bills = $3,302,109.23Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be:

Aftertax cash flow to shareholders = $3,302,109.23(1 – .15)

Aftertax cash flow to shareholders = $2,806,792.85

If the firm invests in preferred stock:

If the firm invests in preferred stock, the assumption would be that the dividends received will be reinvested in the same preferred stock. The preferred stock will pay a dividend of:

Preferred dividend = .07($3,000,000)

Preferred dividend = $210,000

Since 70 percent of the dividends are excluded from tax:

Taxable preferred dividends = (1 – .70)($210,000)

Taxable preferred dividends = $63,000And the taxes the company must pay on the preferred dividends will be:

Taxes on preferred dividends = .35($63,000) Taxes on preferred dividends = $22,050So, the aftertax dividend for the corporation will be:

Aftertax corporate dividend = $210,000 – 22,050

Aftertax corporate dividend = $187,950

This means the aftertax corporate dividend yield is:

After-tax corporate dividend yield = $187,950 / $3,000,000

Aftertax corporate dividend yield = .0627 or 6.27%

The future value of the company‘s investment in preferred stock will be:

FV of investment in preferred stock = $3,000,000(1 + .0627)3

FV of investment in preferred stock = $3,599,912.91Since the future value will be paid to shareholders as a dividend, the after-tax cash flow will be:

After-tax cash flow to shareholders = $3,599,912.91(1 – .15)

After-tax cash flow to shareholders = $3,059,925.97

  Alternative 2:

The firm pays out dividend now, and individuals invest on their own. The after-tax cash received by shareholders now will be:

After-tax cash received today = $3,000,000(1 – .15)

After-tax cash received today = $2,550,000

The individuals invest in Treasury bills:

If the shareholders invest the current after-tax dividends in Treasury bills, the after-tax individual yield will be:

After-tax individual yield on T-bills = .05(1 – .31)

After-tax individual yield on T-bills = .0345 or 3.45%

So, the future value of the individual investment in Treasury bills will be:

FV of investment in T-bills = $2,550,000(1 + .0345)3

FV of investment in T-bills = $2,823,135.12

The individuals invest in preferred stock:

If the individual invests in preferred stock, the assumption would be that the dividends received will be reinvested in the same preferred stock. The preferred stock will pay a dividend of: Preferred dividend = .07($2,550,000)

Preferred dividend = $178,500

And the taxes on the preferred dividends will be:

Taxes on preferred dividends = .31($178,500)

Taxes on preferred dividends = $55,335So, the after-tax preferred dividend will be:

After-tax preferred dividend = $178,500–55,335

After-tax preferred dividend = $123,165

This means the after-tax individual dividend yield is: After-tax corporate dividend yield = $123,165 / $2,550,000Aftertax corporate dividend yield = .0483 or 4.83%

The future value of the individual investment in preferred stock will be: FV of investment in preferred stock = $2,550,000(1 + .0483)3

FV of investment in preferred stock = $2,937,628.94

The after-tax cash flow for the shareholders is maximized when the firm invests the cash in the preferred stocks and pays a special dividend later

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