Assignment
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 2 percent or in 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 20 percent on common stock dividends.
Suppose the company reinvests the $3 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 dividend of $3 million now and the shareholder reinvests the dividend for three years.
What is the total aftertax cash flow to shareholders if the shareholders invest in T-bills?
What is the total aftertax cash flow to shareholders if the shareholders invest in preferred stock?