Question

A corporation has cash flow in excess of investment needs and normal dividend payments. The corporation is considering two alternative uses of the excess funds. In Alternative 1, the corporation increases current dividends. In Alternative 2, the corporation makes a three-year loan and uses the loan proceeds to pay dividends at the end of three years. The following information may be used in choosing between the alternatives. Stockholders can earn 5% after taxes on their investments. The corporate tax rate is 30%. Stockholders currently have a 20% tax rate and tax rate will change to 25% next year. At what pretax return on the loan are stockholders indifferent between the alternatives?

a. 10.0% b. 10.8% c. 9.6% d. 10.4% e. 11.2%

Answer 1

C.9.6%

Workings

Step 1 :Find out average rate of tax

for example,for $1 tax :corporate tax will be 1*30% = $.03 and Stockholder tax will be ($1-$0.3)*25% = $0.18

Total tax = Corporate tax + Stockholders' tax = $0.30+$0.18 =$0.48 or 48 cents.

Average Tax rate = Total Tax/Total Income

Average Tax rate = ($0.3+$0.18)/$1 =.48 or 48%

For $1 average tax rate is 48%

Post tax return 5% means 52 percentage of pretax return

Therefore,pretax return = Post tax return/1-Average tax rate

Pretax return = 5/1-.48 = 9.615% or 9.6%(approx)