Question 17.3: Recall Barston Mining from Example 17.2. Suppose Barston mus...
Recall Barston Mining from Example 17.2. Suppose Barston must pay corporate taxes at a 35% rate on the interest it will earn from the one-year Treasury bill paying 2% interest. Would pension fund investors (who do not pay taxes on their investment income) prefer that Barston use its excess cash to o pay the $100,000 dividend immediately or retain the cash for one year?
PLAN
As in the original example, the comparison is between what shareholders could generate on their own and what shareholders will receive if Barston retains and invests the funds for them. The key question then is: What is the difference between the after-tax return that Barston can earn and distribute to shareholders versus the pension fund’s tax-free return on investing the $100,000?
EXECUTE
Because the pension fund investors do not pay taxes on investment income, the results from the prior example still hold: They would get $100,000, invest it, and earn 2% to receive a total of $102,000 in one year.
If Barston retains the cash for one year, it will earn an after-tax return on the Treasury bills of:
2% \times (1 – 0.35) = 1.30%
Thus, at the end of the year Barston will pay a dividend of 100,000 \times (1.013) = $101,300.
EVALUATE
This amount is less than the $102,000 the investors would have earned if they had invested the $100,000 in Treasury bills themselves. Because Barston must pay corporate taxes on the interest it earns, there is a tax disadvantage to retaining cash. Pension fund investors will therefore prefer that Barston pays the dividend now.