National Business Machine Co. (NBM) has $7 million of extra cash after taxes hav

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 special dividend at the end of three years. In this case, the firm can invest in Treasury bills yielding 2 percent or a 4 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 38 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 10 percent on common stock dividends. 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? What is the total aftertax cash flow to shareholders if the company invests in preferred stock? 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? What is the total aftertax cash flow to shareholders if the shareholder invests in preferred stock?

Explanation / Answer

Since $ 7,000,000 is after tax ,The full amount is invested ,

So the value of each alternative is

Alternative 1

                The firm invest in T-bill or in preferred stock and then pays out as special Dividend in 3 year

If the firm invest in T-bill

If the firm invest in T-bill, The after tax yield on T bill

After Tax corporate yield = 0.02(1- 0.38)

                                   =0.0124

                                    =1.24%

So the future value of corporate investment in Tbill will be

FV = 7,000,000 (1+0.124)3

   =7,000,000*1.03766

=7263642

Since the future value is paid as dividend to share holder ,The after tax cash flow will be

=7263642 * (1-0.10)

=$6,537,278

If the firm invest in preferred stock ,the assumption would be that the dividend received will be invested in the same preferred stock, the preferred stock will be pay dividend of

Proffered Dividend = 0.04(7,000,000)

                                   =2,800,000

Since 70% of dividend are exclude from tax

Taxable preferred Dividend

= (1-0.70) *($ 2800000)

=$ 84,000

Taxable preferred Dividend = $ 84000 and the taxes company must pay on the preferred dividend will be

taxes On preferred Dividend =

=0.38 (840000)

taxes On preferred Dividend =

31920

So the after tax dividend for the corporation will be

=280000- 31920

=$248,080

This means after tax corporate dividend Yield is

after tax corporate dividend Yield is= 248080 /    7000000

                              =0.03544

                          =3.54%

The future value of company investment in preferred stock will be

future value of company investment in preferred stock= (7,000,000) * (1.0354)3

                   =7000,000 *1.1101

             =7770927.452

Since the future value is paid as dividend to share holder ,The after tax cash flow will be

=7770927.452 * (1-0.10)

=$6,993,834.71

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