A corporation has $1,200,000 in cash on its balance sheet that could be used to

Question

A corporation has $1,200,000 in cash on its balance sheet that could be used to pay a special dividend of $5 per share. One of the financial managers of the corporation says that a repurchase of shares using that $1,200,000 would be a better idea because the corporation's investors would save $384,000 in taxes for that tax year (as compared to the special dividend). The manager assumes the dividend tax rate is 40% and the capital gains tax rate is 20%. The manager also assumes that the investors who would sell shares the corporation repurchases bought their shares at an average price of $30 per share. What must be the price of the corporation's stock that will be paid to repurchase shares that the manager assumed in calculating the $384,000 tax savings?

Explanation / Answer

Answer:

Tax savings = $384000

Tax on dividend : 40%

1200000*0.4 = 480000

difference between this tax payment and capital gains tax should be 384000

Tax savings is beacuse of the difference in tax rate of 20%

Lets say price of corporation stock is $X

the capital gains tax would be applicable on the excess amount above $30

Tax paid for Dividend payment - Tax paid for the Capital gains = $384000

480000 - (1200000/X)*(X-30)*0.2 = 384000

Solving this

96000 = (1200000/X)*(X-30)*0.2

0.4 = X-30/X

-0.6X = - 30

X= 50

Price paid to repurchase shares is $50

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