Question

A Company has 1,000 of extra cash. It can retain the cash and invest it in the Treasury bills yielding 10 percent per year, or it can pay the cash to shareholders as a dividend. Shareholders can also invest in Treasury bills with the same yield. The corporate tax rate is 15 percent, and there are no taxes on personal income. However, the maximum tax rate on the dividend income is 10 percent. How much cash will investors have after 5 years under each policy?

Answer 1

Payind Dividends now, will yield shareholders= 1,000*(1-.1)= 900, today after taxes.

Since there are no personal taxes on their returns on Treasury Bills, returns will be at (.10*(1-0)), Hence

Shareholder will have in 5 years= 900*(1.1)^5= 1,449.46

If the Company retains cash to Invest in T-bills, its after tax interest rate would be (.10*(1-.15))=.085

At the end of 5 years, firm will have = 1,000*(1.085)^5 = 1,503.66

If we pay the above proceeds as dividends, investors will receive= 1,503.66*(1-.1)= 1,353.29

This implies that cash to investors will be greater if firm is paying dividend now.

Hope this answers the above question.