FIN 4610 Hw 3

Score: 120 out of 120 points (100%)

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10 out of10.00 points

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Dark Day, Inc., has declared a $5.60 per share dividend. Suppose capital gains are not taxed, but dividendsare 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

WorksheetLearning Objective: 17-02 Theissues surrounding dividend policydecisions.

Dark Day, Inc., has declared a $5.60 per share dividend. Suppose capital gains are not taxed, but dividendsare 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

The owners’ equity accounts for Alexander International are shown here:

Common stock ($0.50 par value) $ 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, howmany new shares will be distributed?

New shares issued 8,000

a-2 Show how the equity accounts would change.

Common stock $ 44,000 Capital surplus 531,000 Retained earnings 538,120 Total owners’ equity $ 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 minussign.)

Common stock $ 50,000 Capital surplus 825,000 Retained earnings 238,120 Total owners’ equity $ 1,113,120

WorksheetLearning Objective: 17-03 Thedifference between cash and stockdividends.

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%

a-2 Show how the equity accounts would change.

Common stock $ 44,000 ± 0.1%

Capital surplus 531,000 ± 0.1%

Retained earnings 538,120 ± 0.1%

Total owners’ equity $ 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 minussign.)

Common stock $ 50,000 ± 0.1%

Capital surplus 825,000 ± 0.01%

Retained earnings 238,120 ± 0.1%

Total owners’ equity $ 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 sharesoutstanding. The shares outstanding increases by 10 percent, so:

New shares outstanding = 80,000(1.10) = 88,000New 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 capitalsurplus is therefore:

Capital surplus on new shares = 8,000($24.50) = $196,000Common stock ($0.50 par value) = $44,000 b.

The shares outstanding increases by 25 percent, so:

New shares outstanding = 80,000(1.25) = 100,000New 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 capitalsurplus is therefore:

Capital surplus on new shares = 20,000($24.50) = $490,000

Common stock ($0.50 par value) = $50,000

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Red Rocks Corporation (RRC) currently has 520,000 shares of stock outstanding that sell for $50 pershare. 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))


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


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


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

a. New shares outstanding 693,333 b. New shares outstanding 624,000 c. New shares outstanding 756,600 d. New shares outstanding 222,857


Red Rocks Corporation (RRC) currently has 520,000 shares of stock outstanding that sell for $50 pershare. 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))


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


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

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

a. New shares outstanding 693,333 ± 0.1%

b. New shares outstanding 624,000 ± 0.1%

c. New shares outstanding 756,600 ± 0.1%

d. New shares outstanding 222,857 ± 0.1%

Explanation:

To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares, so:

a. $50(3/4) = $37.50b. $50(1/1.20) = $41.67c. $50(1/1.455) = $34.36d. $50(7/3) = $116.67

e. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of newshares 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

The balance sheet for Chevelle Corp. is shown here in market value terms. There are 6,000 shares of stockoutstanding.

Market Value Balance Sheet Cash $ 45,500 Equity $ 535,500 Fixed assets 490,000 Total $ 535,500 Total $ 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?

Balance Sheet Cash $ 34,700 Equity $ 524,700 Fixed assets 490,000 Total $ 524,700 Total $ 524,700

WorksheetLearning Objective: 17-01 Dividendtypes and how dividends are paid.

The balance sheet for Chevelle Corp. is shown here in market value terms. There are 6,000 shares of stockoutstanding.

Market Value Balance Sheet Cash $ 45,500 Equity $ 535,500 Fixed assets 490,000 Total $ 535,500 Total $ 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

Cash $ 34,700 Equity $ 524,700

Fixed assets 490,000

Total $ 524,700 Total $ 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

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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.

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

Common stock ($1 par value) $ 430,000 Capital surplus 855,000 Retained earnings 3,810,800 Total owners' equity $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 $ 473,000 Capital surplus 2,360,000 Retained earnings 2,262,800 Total owners' equity $ 5,095,800


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

Common stock ($1 par value) $ 430,000 Capital surplus 855,000 Retained earnings 3,810,800 Total owners' equity $5,095,800

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

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New shares outstanding 473,000 ± 0.1%

What would the equity accounts be after the stock dividend?

Common stock $ 473,000 ± 0.1%

Capital surplus 2,360,000 ± 0.01%

Retained earnings 2,262,800 ± 0.01%

Total owners' equity $ 5,095,800 ± 0.01%

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

The company with the common equity accounts shown here has declared a 4-for-one stock split when themarket value of its stock is $30 per share. The firm’s 75-cent per share cash dividend on the new (postsplit)shares represents an increase of 20 percent over last year’s dividend on the presplit stock.

Common stock ($1 par value) $ 400,000 Capital surplus 849,000 Retained earnings 3,750,800 Total owner's equity $ 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

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WorksheetLearning Objective: 17-03 The

difference between cash and stockdividends.

The company with the common equity accounts shown here has declared a 4-for-one stock split when themarket value of its stock is $30 per share. The firm’s 75-cent per share cash dividend on the new (postsplit)shares represents an increase of 20 percent over last year’s dividend on the presplit stock.

Common stock ($1 par value) $ 400,000 Capital surplus 849,000 Retained earnings 3,750,800 Total owner's equity $ 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 theratio 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. Thecompany had 400,000 shares outstanding before the split. We must remember to adjust the sharesoutstanding 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 year’s 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

You own 2,200 shares of stock in Avondale Corporation. You will receive a $1.40 per share dividend in oneyear. In two years, Avondale will pay a liquidating dividend of $48 per share. The required return on Avondalestock 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 inone 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 anannuity. (Do not round intermediate calculations.)

Cash flow $ 49,680.00


You own 2,200 shares of stock in Avondale Corporation. You will receive a $1.40 per share dividend in oneyear. In two years, Avondale will pay a liquidating dividend of $48 per share. The required return on Avondalestock 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 inone 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 anannuity. (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 thefollowing equation and solve for the dividend (Note: The dividend is a two-year annuity, so we could solvewith 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 stockin 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 you’ll 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 ofshares 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 theYear 2 cash flow is: Year 2 cash flow = $48(2,200 – 1,165.00) = $49,680

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You own 1,800 shares of stock in Avondale Corporation. You will receive a $1.80 per share dividend in oneyear. In two years, Avondale will pay a liquidating dividend of $80 per share. The required return on Avondalestock 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


You own 1,800 shares of stock in Avondale Corporation. You will receive a $1.80 per share dividend in oneyear. In two years, Avondale will pay a liquidating dividend of $80 per share. The required return on Avondalestock 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 presentvalues 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

Rudolph Corporation is evaluating an extra dividend versus a share repurchase. In either case, $20,000would 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 shareholderwealth per share. (Round your answers to 2 decimal places. (e.g., 32.16))

Alternative I Extra dividend Price per share $ 45.00

Shareholder wealth $ 50.00

Alternative II Repurchase Price per share $ 50

Shareholder wealth $ 50

b. What will Rudolph's EPS and PE ratio be under the two different scenarios? (Do not roundintermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Alternative 1 EPS $ 1.50 PE ratio 30.00

Alternative II EPS $ 1.67 PE ratio 30.00

WorksheetLearning Objective: 17-04 Whyshare repurchases are analternative to dividends.

Rudolph Corporation is evaluating an extra dividend versus a share repurchase. In either case, $20,000would be spent. Current earnings are $1.50 per share, and the stock currently sells for $50 per share. Thereare 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 shareholderwealth per share. (Round your answers to 2 decimal places. (e.g., 32.16))

Alternative I Extra dividend

Price per share $ 45.00 ± 1%

Shareholder wealth $ 50.00

Alternative II Repurchase

Price per share $ 50

Shareholder wealth $ 50

b. What will Rudolph's EPS and PE ratio be under the two different scenarios? (Do not roundintermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16))

Alternative 1

EPS $ 1.50 ± 1%

PE ratio 30.00 ± 1%

Alternative II

EPS $ 1.67 ± 1%

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 thecompany 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 theirshares, they’re 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 EPStimes the current number of shares outstanding. Dividing net income by the new number of sharesoutstanding, 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

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10 out of

The Gecko Company and the Gordon Company are two firms whose business risk is the same but thathave different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of2 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Geckohas an expected earnings growth rate of 20 percent annually, and its stock price is expected to grow at thissame rate. The aftertax expected returns on the two stocks are equal (because they are in the same riskclass).

What is the pretax required return on Gordon’s stock? (Round your answer to 2 decimal places. (e.g.,32.16))

Pretax return 20.60 %


The Gecko Company and the Gordon Company are two firms whose business risk is the same but thathave different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of2 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Geckohas an expected earnings growth rate of 20 percent annually, and its stock price is expected to grow at thissame rate. The aftertax expected returns on the two stocks are equal (because they are in the same riskclass).

What is the pretax required return on Gordon’s 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%

10.00 points

You did not receive credit for this question in a previous attempt

As discussed in the text, in the absence of market imperfections and tax effects, we would expect theshare price to decline by the amount of the dividend payment when the stock goes ex dividend. Once weconsider 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 percentexemption from taxation on the dividend income they receive, but they do not get such an exemption oncapital gains. If the corporation’s income and capital gains tax rates are both 34 percent, what does thismodel 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 Economicsand Statistics 52 (February 1970).


As discussed in the text, in the absence of market imperfections and tax effects, we would expect theshare price to decline by the amount of the dividend payment when the stock goes ex dividend. Once weconsider 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?

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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))


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


1N. Elton and M. Gruber, “Marginal Stockholder Tax Rates and the Clientele Effect,” Review of Economicsand Statistics 52 (February 1970).

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 dividendexemption percentage, so: P0 – PX = D[1 – (0.34)(0.30)]/(1 – 0.34)

P0 – PX = 1.3606D

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

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 toreceive the dividend or to let Carlson invest the money?

Personal tax rate 31 %

b. Is the answer to (a) reasonable? Yes

c. Suppose the only investment choice is a preferred stock that yields 9 percent. The corporate dividendexclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to theoutcome of Carlson’s dividend decision? (Do not round intermediate calculations and round yourfinal answer to 2 decimal places. (e.g., 32.16))

Personal tax rate 9.30 %

d. Is this a compelling argument for a low dividend-payout ratio? Yes

WorksheetLearning Objective: 17-02 Theissues surrounding dividend policy

decisions.

After completing its capital spending for the year, Carlson Manufacturing has $2,300 extra cash. Carlson’smanagers must choose between investing the cash in Treasury bonds that yield 5 percent or paying thecash 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 toreceive the dividend or to let Carlson invest the money?

Personal tax rate 31 ± 1% %

b. Is the answer to (a) reasonable? Yes

c. Suppose the only investment choice is a preferred stock that yields 9 percent. The corporate dividendexclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to theoutcome of Carlson’s dividend decision? (Do not round intermediate calculations and round yourfinal answer to 2 decimal places. (e.g., 32.16))

Personal tax rate 9.30 ± 1% %

d. Is this a compelling argument for a low dividend-payout ratio?

Yes

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 investor’s proceeds must be the same whether she invests the aftertax dividend orreceives the proceeds from the firm’s investment and pays taxes on that amount. To find the rate at whichthe 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 investmentin 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 isexempt 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 instock of other companies.

FIN 4610 Hw 3

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Transcript of FIN 4610 Hw 3