MIDSTRATA Co. has $3 million of extra cash after taxes have been paid. It has two choices to make use of this cash. First 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 3% or a 5% preferred stock. CRA regulations allow the company to exclude from taxable income 100% of the dividends received from investing in another company’s stock. Second 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 35%. Assume the investor has a 31% personal income tax rate, which is applied to interest income. The personal dividend tax rate is 15% on common stock dividends after applying the dividend tax credit.
a) Should the cash be paid today or in three years?
b) Which of the two options generates the highest after-tax income for the shareholders?Get Finance homework help today
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