Question

a. After completing its capital spending for the year, H Manufacturing has $1,000
extra cash. H’s managers must choose between investing the cash in Treasury
bonds that yield 8% or paying the cash out to investors who would invest in the bonds
themselves.
i. If the corporate tax rate is 35%, what personal tax rate would make the investors
equally willing to receive the dividend or to let H invest the money?
ii. Is the answer to part i) reasonable? Explain.
b. The desire for high current income is a valid explanation of preference for high current
dividend policy. Comment on the validity of this statement.

Answer 1

Answer (i)

Investors will be equally willing to receive dividend or let H invest money, if Personal tax rate is also at 35%. As in both scenarios net interest cash flow will be same to investor, Assuming there is no tax on payment of dividend by company and on receipt of dividend by investors.

Answer (ii)

Investors being equally willing to receive dividend or let H invest money may not be and ideal solution for investors. If investor choose to receive dividend, then he is sure to receive dividend and return on investment of dividend. But incase of H invest money, there may be chances that H may not be able to pay full amount. In that case investor's cash flow will be low.

Answer (iii)

High current income always lures investors, hence they prefer high current dividend. If investor has a chance to get income in present compared to future time, they will prefer current income as future is uncertain. but dividend policy may not be made due to this desire. high dividend can be paid in case company is earning high profits and doesn't have any investment opportunity. there may be other reasons for high dividend policy as well.