Question

Metal is currently trading for $40 per share and is about to pay a $5 special dividend. And, the tax rate on dividend is 40%, the tax rate on capital gains is 20%. Suppose that Metal made a surprise announcement that it would do a share repurchase rather than pay a special dividend, the net tax savings per share for an investor that would result from this decision is closest to:

Select one:

a. $3.75

b. $4.00

c. $5.00

d. $1.25

Answer 1

Correct Answer is d) $1.25

Working Notes:

First let us determine the Tax rate

Tax rate =( Dividend tax rate - capital gan tax rate ) / (1- capital gain tax rate)

= (0.4-0.2) /(1-0.2)

tax rate = 25%

Next step is to determine the share price after the declaration of special dividend of $ 6

Share Price after announcement = Current market value - special dividend (1- tax rate)

= 40 - 5 (1-0.25)

Share Price after declaration = $36.25

Capital Loss = Share Price after announcement - Current Market Value

= 36.25 -40

Capital Loss =(-3.75)

Tax on Capital Loss = Capital loss x Capital gain tax rate

=3.75 x 20%

Tax on Capital Loss =0.75

Tax on Dividend = Dividend x Tax rate on dividend

= 5 x 40%

Tax on Dividend = 2

Net Tax Saving = Tax on dividend - Tax on capital loss

= 2-0.75

Net Tax Saving =1.25