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Mar 02, 2014

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corporate finance 3

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corporate finance 3

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1.

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Dark Day, Inc., has declared a $5.60 per share dividend. Suppose capital gains are not taxed, but dividends are taxed at 15 percent. New IRS regulations require that taxes be withheld at the time the dividend is paid. Dark Day sells for $94.10 per share, and the stock is about to go ex-dividend. What do you think the ex-dividend price will be? (Round your answer to 2 decimal places. (e.g., 32.16)) Ex-dividend price $ 89.34

Worksheet

Dark Day, Inc., has declared a $5.60 per share dividend. Suppose capital gains are not taxed, but dividends are taxed at 15 percent. New IRS regulations require that taxes be withheld at the time the dividend is paid. Dark Day sells for $94.10 per share, and the stock is about to go ex-dividend. What do you think the ex-dividend price will be? (Round your answer to 2 decimal places. (e.g., 32.16)) Ex-dividend price $ 89.34 1%

Explanation:

The aftertax dividend is the pretax dividend times one minus the tax rate, so: Aftertax dividend = $5.60(1 0.15) = $4.76 The stock price should drop by the aftertax dividend amount, or: Ex-dividend price = $94.10 4.76 = $89.34

2.

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The owners equity accounts for Alexander International are shown here:

40,000

Common stock ($0.50 par value) $ 40,000 Capital surplus 335,000 Retained earnings 738,120 Total owners equity $ 1,113,120

a -1 If Alexander stock currently sells for $25 per share and a 10 percent stock dividend is declared, how many new shares will be distributed? New shares issued 8,000

a-2 Show how the equity accounts would change. Common stock Capital surplus Retained earnings Total owners equity $ 44,000 531,000 538,120 $ 1,113,120

b-1 If instead Alexander declared a 25 percent stock dividend, how many new shares will be distributed? New shares issued 20,000

b-2 Show how the equity accounts would change. (Negative amount should be indicated by a minus sign.) Common stock Capital surplus Retained earnings Total owners equity $ 50,000 825,000 238,120 $ 1,113,120

Worksheet

Learning Objective: 17-03 The difference between cash and stock dividends.

The owners equity accounts for Alexander International are shown here: Common stock ($0.50 par value) $ 40,000 Capital surplus 335,000 Retained earnings 738,120 Total owners equity $ 1,113,120

a -1 If Alexander stock currently sells for $25 per share and a 10 percent stock dividend is declared, how many new shares will be distributed? New shares issued 8,000 0.1%

1,113,120 0.01%

b-1 If instead Alexander declared a 25 percent stock dividend, how many new shares will be distributed? New shares issued 20,000 0.01%

b-2 Show how the equity accounts would change. (Negative amount should be indicated by a minus sign.)

1,113,120 0.01%

Explanation: a.

Since the par value is $0.50 and the common stock account is $40,000, there are 80,000 shares outstanding. The shares outstanding increases by 10 percent, so: New shares outstanding = 80,000(1.10) = 88,000 New shares issued = 8,000 Since the par value of the new shares is $0.50, the capital surplus per share is $24.50. The total capital surplus is therefore: Capital surplus on new shares = 8,000($24.50) = $196,000 Common stock ($0.50 par value) = $44,000

b.

The shares outstanding increases by 25 percent, so: New shares outstanding = 80,000(1.25) = 100,000 New shares issued = 20,000 Since the par value of the new shares is $0.50, the capital surplus per share is $24.50. The total capital surplus is therefore: Capital surplus on new shares = 20,000($24.50) = $490,000 Common stock ($0.50 par value) = $50,000

3.

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Red Rocks Corporation (RRC) currently has 520,000 shares of stock outstanding that sell for $50 per share. Assuming no market imperfections or tax effects exist, what will the share price be after: a. RRC has a four-for-three stock split? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 37.50

b. RRC has a 20 percent stock dividend? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 41.67

c. RRC has a 45.5 percent stock dividend? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 34.36

d. RRC has a three-for-seven reverse stock split? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 116.67

Determine the new number of shares outstanding in parts (a) through (d). a. b. c. d. New shares New shares New shares New shares outstanding outstanding outstanding outstanding 693,333 624,000 756,600 222,857

Worksheet

Learning Objective: 17-03 The difference between cash and stock dividends.

Red Rocks Corporation (RRC) currently has 520,000 shares of stock outstanding that sell for $50 per share. Assuming no market imperfections or tax effects exist, what will the share price be after: a. RRC has a four-for-three stock split? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 37.50 1%

b. RRC has a 20 percent stock dividend? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 41.67 1%

c. RRC has a 45.5 percent stock dividend? (Round your answer to 2 decimal places. (e.g., 32.16)) New share price $ 34.36 1%

d. RRC has a three-for-seven reverse stock split? (Round your answer to 2 decimal places. (e.g., 32.16))

116.67 1%

Determine the new number of shares outstanding in parts (a) through (d).

a. New shares outstanding b. New shares outstanding c. New shares outstanding d. New shares outstanding

Explanation:

To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares, so: a. b. c. d. $50(3/4) = $37.50 $50(1/1.20) = $41.67 $50(1/1.455) = $34.36 $50(7/3) = $116.67

e. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: a: 520,000(4/3) = 693,333 b: 520,000(1.20) = 624,000 c: 520,000(1.455) = 756,600 d: 520,000(3/7) = 222,857

4.

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The balance sheet for Chevelle Corp. is shown here in market value terms. There are 6,000 shares of stock outstanding. Market Value Balance Sheet Cash $ 45,500 Equity Fixed assets 490,000 Total $ 535,500 Total $ 535,500

$ 535,500

The company has declared a dividend of $1.80 per share. The stock goes ex dividend tomorrow. Ignoring any tax effects, what is the stock selling for today? (Round your answer to 2 decimal places. (e.g., 32.16)) Stock selling price $ 89.25 per share

Ignoring any tax effects, what will it sell for tomorrow? (Round your answer to 2 decimal places. (e.g., 32.16)) Stock selling price $ 87.45 per share

Ignoring any tax effects, what will the balance sheet look like after the dividends are paid?

$ 524,700

$ 524,700

$ 524,700

Worksheet

Learning Objective: 17-01 Dividend types and how dividends are paid.

The balance sheet for Chevelle Corp. is shown here in market value terms. There are 6,000 shares of stock outstanding. Market Value Balance Sheet Cash $ 45,500 Equity Fixed assets 490,000 Total $ 535,500 Total $ 535,500

$ 535,500

The company has declared a dividend of $1.80 per share. The stock goes ex dividend tomorrow. Ignoring any tax effects, what is the stock selling for today? (Round your answer to 2 decimal places. (e.g., 32.16)) Stock selling price $ 89.25 1% per share

Ignoring any tax effects, what will it sell for tomorrow? (Round your answer to 2 decimal places. (e.g., 32.16)) Stock selling price $ 87.45 1% per share

Ignoring any tax effects, what will the balance sheet look like after the dividends are paid? Balance Sheet 34,700 Equity 490,000 $ 524,700 Total $ 524,700

524,700

Explanation:

The stock price is the total market value of equity divided by the shares outstanding, so: P0 = $535,500 equity/6,000 shares = $89.25 per share Ignoring tax effects, the stock price will drop by the amount of the dividend, so: PX = $89.25 1.80 = $87.45

The total dividends paid will be: $1.80 per share(6,000 shares) = $10,800 The equity and cash accounts will both decline by $10,800.

5.

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The company with the common equity accounts shown here has declared a 10 percent stock dividend when the market value of its stock is $36 per share. Common stock ($1 par value) Capital surplus Retained earnings Total owners' equity $ 430,000 855,000 3,810,800 $ 5,095,800

What would be the number of shares outstanding, after the distribution of the stock dividend? New shares outstanding 473,000

What would the equity accounts be after the stock dividend? Common stock Capital surplus Retained earnings Total owners' equity $ 473,000 2,360,000 2,262,800 $ 5,095,800

Worksheet

Learning Objective: 17-03 The difference between cash and stock dividends.

The company with the common equity accounts shown here has declared a 10 percent stock dividend when the market value of its stock is $36 per share.

Common stock ($1 par value) Capital surplus Retained earnings Total owners' equity

What would be the number of shares outstanding, after the distribution of the stock dividend?

473,000 0.1%

Explanation:

With a stock dividend, the shares outstanding will increase by one plus the dividend amount, so: New shares outstanding = 430,000(1.10) = 473,000 The capital surplus is the capital paid in excess of par value, which is $1, so: Capital surplus for new shares = 43,000($35) = $1,505,000 The new capital surplus will be the old capital surplus plus the additional capital surplus for the new shares, so: Capital surplus = $855,000 + 1,505,000 = $2,360,000

6.

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The company with the common equity accounts shown here has declared a 4-for-one stock split when the market value of its stock is $30 per share. The firms 75-cent per share cash dividend on the new (postsplit) shares represents an increase of 20 percent over last years dividend on the presplit stock. Common stock ($1 par value) Capital surplus Retained earnings Total owner's equity $ 400,000 849,000 3,750,800

$ 4,999,800

What is the new par value per share? (Round your answer to 2 decimal places. (e.g., 32.16)) New par value $ 0.25 per share

What was last year's dividend per share? (Round your answer to 2 decimal places. (e.g., 32.16)) Dividend per share $ 2.50

Worksheet

Learning Objective: 17-03 The difference between cash and stock dividends.

The company with the common equity accounts shown here has declared a 4-for-one stock split when the market value of its stock is $30 per share. The firms 75-cent per share cash dividend on the new (postsplit) shares represents an increase of 20 percent over last years dividend on the presplit stock. Common stock ($1 par value) Capital surplus Retained earnings Total owner's equity $ 400,000 849,000 3,750,800

$ 4,999,800

What is the new par value per share? (Round your answer to 2 decimal places. (e.g., 32.16)) New par value $ 0.25 per share

What was last year's dividend per share? (Round your answer to 2 decimal places. (e.g., 32.16)) Dividend per share $ 2.50 1%

Explanation:

The only equity account that will be affected is the par value of the stock. The par value will change by the ratio of old shares to new shares, so: New par value = $1(1/4) = $0.25 per share The total dividends paid this year will be the dividend amount times the number of shares outstanding. The company had 400,000 shares outstanding before the split. We must remember to adjust the shares outstanding for the stock split, so: Total dividends paid this year = $0.75(400,000 shares)(4/1 split) = $1,200,000 The dividends increased by 20 percent, so the total dividends paid last year were: Last years dividends = $1,200,000/1.20 = $1,000,000.00 And to find the dividends per share, we simply divide this amount by the shares outstanding last year. Doing so, we get: Dividends per share last year = $1,000,000.00/400,000 shares = $2.50

7.

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You own 2,200 shares of stock in Avondale Corporation. You will receive a $1.40 per share dividend in one year. In two years, Avondale will pay a liquidating dividend of $48 per share. The required return on Avondale stock is 20 percent.

Ignoring taxes, what is the current share price of your stock? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Share price $ 34.50

If you would rather have equal dividends in each of the next two years, how many shares would you sell in one year? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Number of shares $ 1,165.00

What would your cash flow be for each year for the next two years? Hint: Dividends will be in the form of an annuity. (Do not round intermediate calculations.) Cash flow $ 49,680.00

Worksheet

You own 2,200 shares of stock in Avondale Corporation. You will receive a $1.40 per share dividend in one year. In two years, Avondale will pay a liquidating dividend of $48 per share. The required return on Avondale stock is 20 percent. Ignoring taxes, what is the current share price of your stock? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Share price $ 34.50 0.1%

If you would rather have equal dividends in each of the next two years, how many shares would you sell in one year? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Number of shares $ 1,165.00 0.1%

What would your cash flow be for each year for the next two years? Hint: Dividends will be in the form of an annuity. (Do not round intermediate calculations.) Cash flow $ 49,680.00 1%

Explanation:

The price of the stock today is the PV of the dividends, so: P0 = $1.40/1.20 + $48/1.202 = $34.50 To find the equal two-year dividends with the same present value as the price of the stock, we set up the following equation and solve for the dividend (Note: The dividend is a two-year annuity, so we could solve with the annuity factor as well): $34.50 = D/1.20 + D/1.202 D = $22.58

We now know the cash flow per share we want each of the next two years. We can find the price of stock in one year, which will be: P1 = $48/1.20 = $40.00 Since you own 2,200 shares, in one year you want: Cash flow in Year 1 = 2,200($22.58) = $49,680 But youll only get: Dividends received in one year = 2,200($1.40) = $3,080 Thus, in one year you will need to sell additional shares in order to increase your cash flow. The number of shares to sell in year one is: Shares to sell at time one = ($49,680 3,080)/$40.00 = 1,165.00 shares At Year 2, you cash flow will be the dividend payment times the number of shares you still own, so the Year 2 cash flow is: Year 2 cash flow = $48(2,200 1,165.00) = $49,680

8.

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You own 1,800 shares of stock in Avondale Corporation. You will receive a $1.80 per share dividend in one year. In two years, Avondale will pay a liquidating dividend of $80 per share. The required return on Avondale stock is 25 percent. Suppose you want only $600 total in dividends the first year. What will your homemade dividend be in two years? (Do not round intermediate calculations.) Homemade dividend $ 147,300

Worksheet

You own 1,800 shares of stock in Avondale Corporation. You will receive a $1.80 per share dividend in one year. In two years, Avondale will pay a liquidating dividend of $80 per share. The required return on Avondale stock is 25 percent. Suppose you want only $600 total in dividends the first year. What will your homemade dividend be in two years? (Do not round intermediate calculations.) Homemade dividend $ 147,300 0.1%

Explanation:

The price of the stock in one year will be: P1 = $80/1.25 = $64.00 If you only want $600 in Year 1, you will buy: ($3,240 600)/$64.00 = 41.25 shares at Time 1. Your dividend payment in Year 2 will be: Year 2 dividend = (1,800 + 41.25)($80) = $147,300 Note, the present value of each cash flow stream is the same. Below we show this by finding the present values as: PV = $600/1.25 + $147,300/1.252 = $94,752.00 PV = 1,800($1.80)/1.25 + 1,800($80)/1.252 = $94,752.00

9.

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Rudolph Corporation is evaluating an extra dividend versus a share repurchase. In either case, $20,000 would be spent. Current earnings are $1.50 per share, and the stock currently sells for $50 per share. There

are 4,000 shares outstanding. Ignore taxes and other imperfections. a. Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholder wealth per share. (Round your answers to 2 decimal places. (e.g., 32.16)) Alternative I Price per share Shareholder wealth Alternative II Price per share Shareholder wealth Extra dividend $ 45.00 $ 50.00 Repurchase $ 50 $ 50

b. What will Rudolph's EPS and PE ratio be under the two different scenarios? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) Alternative 1 EPS PE ratio Alternative II EPS PE ratio $ 1.67 30.00 $ 1.50 30.00

Worksheet

Rudolph Corporation is evaluating an extra dividend versus a share repurchase. In either case, $20,000 would be spent. Current earnings are $1.50 per share, and the stock currently sells for $50 per share. There are 4,000 shares outstanding. Ignore taxes and other imperfections. a. Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholder wealth per share. (Round your answers to 2 decimal places. (e.g., 32.16)) Alternative I Price per share Shareholder wealth Alternative II Price per share Shareholder wealth Extra dividend $ 45.00 1% $ 50.00

Repurchase $ $

50 50

b. What will Rudolph's EPS and PE ratio be under the two different scenarios? (Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) Alternative 1 $ 1.50 1% 30.00 1% Alternative II $ 1.67 1%

EPS PE ratio

EPS

PE ratio

30.00 1%

Explanation: a.

If the company makes a dividend payment, we can calculate the wealth of a shareholder as: Dividend per share = $20,000/4,000 shares = $5.00 The stock price after the dividend payment will be: PX = $50 5.00 = $45.00 per share The shareholder will have a stock worth $45.00 and a $5.00 dividend for a total wealth of $50. If the company makes a repurchase, the company will repurchase: Shares repurchased = $20,000/$50 = 400.00 shares If the shareholder lets their shares be repurchased, they will have $50 in cash. If the shareholder keeps their shares, theyre still worth $50.

b.

If the company pays dividends, the current EPS is $1.50, and the P/E ratio is: P/E = $45.00/$1.5 = 30.00 If the company repurchases stock, the number of shares will decrease. The total net income is the EPS times the current number of shares outstanding. Dividing net income by the new number of shares outstanding, we find the EPS under the repurchase is: EPS = $1.5(4,000)/(4,000 400.00) = $1.67 The stock price will remain at $50 per share, so the P/E ratio is: P/E = $50/$1.67 = 30.00

10.

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The Gecko Company and the Gordon Company are two firms whose business risk is the same but that have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 2 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 20 percent annually, and its stock price is expected to grow at this same rate. The aftertax expected returns on the two stocks are equal (because they are in the same risk class). What is the pretax required return on Gordons stock? (Round your answer to 2 decimal places. (e.g., 32.16)) Pretax return 20.60 %

Worksheet

The Gecko Company and the Gordon Company are two firms whose business risk is the same but that have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 2 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 20 percent annually, and its stock price is expected to grow at this same rate. The aftertax expected returns on the two stocks are equal (because they are in the same risk class). What is the pretax required return on Gordons stock? (Round your answer to 2 decimal places. (e.g., 32.16)) Pretax return 20.60 1% %

Explanation:

Assuming no capital gains tax, the aftertax return for the Gordon Company is the capital gains growth rate, plus the dividend yield times 1 minus the tax rate. Using the constant growth dividend model, we get: Aftertax return = g + D(1 t) = 0.20 Solving for g, we get: 0.20 = g + 0.02(1 0.30) g = 0.1860 The equivalent pretax return for Gordon Company is: Pretax return = g + D = 0.1860 + 0.02 = 0.2060, or 20.60%

11.

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As discussed in the text, in the absence of market imperfections and tax effects, we would expect the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-dividend price:1 (P0 PX)/D = (1 TP)/(1 TG ) where P0 is the price just before the stock goes ex, PX is the ex-dividend share price, D is the amount of the dividend per share, TP is the relevant marginal personal tax rate on dividends, and TG is the effective marginal tax rate on capital gains. a. If TP = TG = 0, how much will the share price fall when the stock goes ex? D b. If TP = 12 percent and TG = 0, how much will the share price fall? (Round your answer to 2 decimal places. (e.g., 32.16)) Share price 0.88 D

c. If TP = 12 percent and TG = 24 percent, how much will the share price fall? (Round your answer to 4 decimal places. (e.g., 32.1616)) Share price 1.1600 D

d. Suppose the only owners of stock are corporations. Recall that corporations get at least a 70 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporations income and capital gains tax rates are both 34 percent, what does this model predict the ex-dividend share price will be? (Round your answer to 4 decimal places. (e.g., 32.1616)) Share price 1.3600 D

1N. Elton and M. Gruber, Marginal Stockholder Tax Rates and the Clientele Effect, Review of Economics

Worksheet

As discussed in the text, in the absence of market imperfections and tax effects, we would expect the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-dividend price:1 (P0 PX)/D = (1 TP)/(1 TG ) where P0 is the price just before the stock goes ex, PX is the ex-dividend share price, D is the amount of the dividend per share, TP is the relevant marginal personal tax rate on dividends, and TG is the effective marginal tax rate on capital gains. a. If TP = TG = 0, how much will the share price fall when the stock goes ex?

D b. If TP = 12 percent and TG = 0, how much will the share price fall? (Round your answer to 2 decimal places. (e.g., 32.16)) Share price 0.88 1% D

c. If TP = 12 percent and TG = 24 percent, how much will the share price fall? (Round your answer to 4 decimal places. (e.g., 32.1616)) Share price 1.1579 1% D

d. Suppose the only owners of stock are corporations. Recall that corporations get at least a 70 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporations income and capital gains tax rates are both 34 percent, what does this model predict the ex-dividend share price will be? (Round your answer to 4 decimal places. (e.g., 32.1616)) Share price 1.3606 1% D

1N. Elton and M. Gruber, Marginal Stockholder Tax Rates and the Clientele Effect, Review of Economics

Explanation:

Using the equation for the decline in the stock price ex-dividend for each of the tax rate policies, we get: (P0 PX)/D = (1 TP)/(1 TG ) a. P0 PX = D(1 0)/(1 0) P0 PX = D b. P0 PX = D(1 0.12)/(1 0) P0 PX = 0.88D c. P0 PX = D(1 0.12)/(1 0.24) P0 PX = 1.1579D d. With this tax policy, we simply need to multiply the personal tax rate times one minus the dividend exemption percentage, so: P0 PX = D[1 (0.34)(0.30)]/(1 0.34) P0 PX = 1.3606D

12.

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After completing its capital spending for the year, Carlson Manufacturing has $2,300 extra cash. Carlsons

managers must choose between investing the cash in Treasury bonds that yield 5 percent or paying the cash out to investors who would invest in the bonds themselves. a. If the corporate tax rate is 31 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money? Personal tax rate b. Is the answer to (a) reasonable? Yes c. Suppose the only investment choice is a preferred stock that yields 9 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of Carlsons dividend decision? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Personal tax rate 9.30 % 31 %

Worksheet

After completing its capital spending for the year, Carlson Manufacturing has $2,300 extra cash. Carlsons managers must choose between investing the cash in Treasury bonds that yield 5 percent or paying the cash out to investors who would invest in the bonds themselves. a. If the corporate tax rate is 31 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money? Personal tax rate b. Is the answer to (a) reasonable? Yes c. Suppose the only investment choice is a preferred stock that yields 9 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of Carlsons dividend decision? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Personal tax rate 9.30 1% % 31 1% %

Explanation: a.

Let x be the ordinary income tax rate. The individual receives an aftertax dividend of: Aftertax dividend = $2,300(1 x) which she invests in Treasury bonds. The Treasury bond will generate aftertax cash flows to the investor of: Aftertax cash flow from Treasury bonds = $2,300(1 x)[1 + 0.05(1 x)] If the firm invests the money, its proceeds are: Firm proceeds = $2,300[1 + 0.05(1 0.31)] And the proceeds to the investor when the firm pays a dividend will be: Proceeds if firm invests first = (1 x){$2,300[1 + 0.05(1 0.31)]} To be indifferent, the investors proceeds must be the same whether she invests the aftertax dividend or receives the proceeds from the firms investment and pays taxes on that amount. To find the rate at which the investor would be indifferent, we can set the two equations equal, and solve for x. Doing so, we find: $2,300(1 x)[1 + 0.05(1 x)] = (1 x){$2,300[1 + 0.05(1 .31)]} 1 + 0.05(1 x) = 1 + 0.05(1 0.31) x = 0.31, or 31% Note that this argument does not depend upon the length of time the investment is held.

b.

Yes, this is a reasonable answer. She is only indifferent if the aftertax proceeds from the $2,300 investment in identical securities are identical. That occurs only when the tax rates are identical.

c.

Since both investors will receive the same pre-tax return, you would expect the same answer as in part a. Yet, because Carlson enjoys a tax benefit from investing in stock (70 percent of income from stock is exempt from corporate taxes), the tax rate on ordinary income which induces indifference, is much lower. Again, set the two equations equal and solve for x: $2,300(1 x)[1 + 0.09(1 x)] = (1 x)($2,300{1 + 0.09[0.70 + (1 0.70)(1 0.31)]}) 1 + 0.09(1 x) = 1 + 0.09[0.70 + (1 0.70)(1 0.31)] x = 0.0930, or 9.30%

d.

It is a compelling argument, but there are legal constraints, which deter firms from investing large sums in stock of other companies.

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