Firm ABC\' stock price is currently $100 and there are 1 million shares outstand

Question

Firm ABC' stock price is currently $100 and there are 1 million shares outstanding. All investors in firm ABC purchased their stock 5 years ago when the price was $50. ABC is sitting on top of $10 million in extra cash that it does not need to fund its operations. With the exception of possible income from this cash, the earnings of ABC are expected to be constant for the foreseeable future. The corporate tax rate is 35%, the personal tax rate on interest income is 30%, and the personal tax rate on dividends and capital gains is 15%. ABC is considering the following options:

(a) Pay the $10 million out in a special dividend today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years.

(b) Pay the $10 million out in the form of a share repurchase today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years

(c) Hold onto the cash and invest it in T-bills offering an 8% return. Pay the cash and interest out to investors in the form of a special dividend after 5 years.vv

Explanation / Answer

(a) Pay the $10 million out in a special dividend today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years.

This will attract 15% dividends tax so after tax investible amount would be = 10*(1-15%)

after tax investible amount =$8.5 Million

Returns after 5 yearscan be calculated using compund interest formula as follows

= 8.5*(1.08)^5

Amount after 5 years=12.49 Million

b) Pay the $10 million out in the form of a share repurchase today to investors who will invest the cash in T-bills offering an 8% return for the next 5 years

Current share Price is $100 and their is $10 million cash so number of shares repurchased would be

=$10 million/100

number of shares repurchased=100000

Capital Gains for each share = 100-50 =$50

Total Capital Gain= 50*100000=5Million

This 5 million will be taxed at 15%.. so after tax capital gain= 5*(1-15%)=4.25 Million

Thus total investible amount= (5+4.25)

Amount after 5 years= 9.25*(1.08)^5

Amount after 5 years =$13.59 Million

c) Hold onto the cash and invest it in T-bills offering an 8% return. Pay the cash and interest out to investors in the form of a special dividend after 5 years.

Amount after 5 years= 10*(1.08)^5

Amount after 5 years=14.69 Million

But special dividend will attract 15% tax

so amount after tax=14.69*(1-15%)

Amount after tax=12.49 Million

Thus from above 3 options company can choose from 1 or 3 as both give same results

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