12) Consider the following equation:
Pcum – Pex = Div ×
The term τd is:
A) the price per share after a dividend is paid.
B) the price per share before a dividend is paid.
C) the personal tax rate for capital gains.
D) the personal tax rate for dividend.
13) Which of the following equations is INCORRECT?
A) Pcum – Pex = Div ×
B) Pcum – Pex = Div ×
C) =
D) (Pcum – Pex)(1 – τd) = Div(1 – τg)
Use the information for the question(s) below.
Consider the following tax rates:
Year
Capital
Gains
Rate
Ordinary
Income Rate
Dividend
Rate
1997-2000
20%
40%
40%
2001-2002
20%
39%
39%
2003–
15%
35%
15%
*The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates shown are
for financial assets held for one year. For assets held less than one year, capital gains are taxed at the
ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the
assets are held for less than 61 days.
14) The effective dividend tax rate for a buy and hold individual investor in 2006 is closest to:
A) 0%
B) 35%
C) 15%
D) 20%
15) The effective dividend tax rate for a one-year individual investor in 2006 is closest to:
A) 20%
B) 15%
C) 35%
D) 0%
16) The effective dividend tax rate for a pension fund in 2006 is closest to:
A) 20%
B) 0%
C) 25%
D) 15%
17) The effective dividend tax rate for a buy and hold individual investor in 1999 is closest to:
A) 25%
B) 0%
C) 20%
D) 40%
18) The effective dividend tax rate for a one-year individual investor in 1999 is closest to:
A) 0%
B) 20%
C) 25%
D) 40%
19) The effective dividend tax rate for a pension fund in 1999 is closest to:
A) 40%
B) 20%
C) 0%
D) 25%
20) Using the available tax information for 2002, calculate the effective dividend tax rate for a:
(1) one-year individual investor
(2) buy and hold individual investor
(3) pension fund
17.5 Payout Versus Retention of Cash
Use the following information to answer the question(s) below.
d’Anconia Copper has $200 million in cash that it can use for a share repurchase. Suppose instead that
d’Anconia Copper invests the funds in an account paying 5% interest for one year. Assume that the
corporate tax rate is 35%, the individual capital gains rate is 15% and the individual rate on ordinary
income is 30%.
1) The amount of additional cash that d’Anconia Copper will have at the end of the year net of corporate
taxes is closest to:
A) $2.0 million
B) $5.5 million
C) $6.5 million
D) $7.0 million
2) Net of capital gains taxes, the amount the total value of d’Anconia Copper shares increase is closest
to:
A) $5.5 million
B) $6.5 million
C) $7.0 million
D) $10.0 million
3) Net of ordinary income taxes, the amount that investors would have if they invested the $200 million
on their own is closest to:
A) $5.5 million
B) $6.5 million
C) $7.0 million
D) $10.0 million
4) Suppose that d’Anconia Copper retained the $200 million in cash so that it would not need to raise
new funds from outside investors for an expansion it has planned for next year. If it did raise new
funds, it would have to pay issuance fees. Assuming that these fees can be expensed for corporate tax
purposes, the amount that d’Anconia Copper needs to save in issuance fees to make retaining the cash
beneficial for its investors is closest to:
A) $2.0 million
B) $5.5 million
C) $6.5 million
D) $7.0 million
5) Which of the following statements is FALSE?
A) In perfect capital markets, buying and selling securities is a zero-NPV transaction, so it should not
affect firm value.
B) Making positive-NPV investments will create value for the firm’s investors, whereas saving the cash
or paying it out will not.
C) In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s choice
of payout versus retention is irrelevant and does not affect the initial share price.
D) After adjusting for investor taxes, there remains a substantial tax advantage for the firm to retain
excess cash.
6) Which of the following statements is FALSE?
A) A firm must balance the tax costs of holding cash with the potential benefits of having to raise
external funds in the future.
B) Paying out excess cash through dividends or share repurchases can boost the stock price by reducing
managers’ ability and temptation to waste resources.
C) If there is a reasonable likelihood that future earnings will be insufficient to fund future positive–
NPV investment opportunities, a firm may start accumulating cash to make up the difference.
D) According to the managerial entrenchment theory of payout policy, managers pay out cash only
when pressured to do so by the firm’s investors.
7) Which of the following formulas is INCORRECT?
A) τ*retain =
B) Pretain =
C) Pretain = Pcum ×
D) Pretain = Pcum × (1 – τ*retain)
8) Consider the following equation:
Pretain = Pcum ×
The term τi in this equation represents:
A) the corporation’s tax rate on interest income.
B) the investor’s tax rate on capital gains.
C) the investor’s tax rate on interest income.
D) the investor’s tax rate on cumulative dividends.
9) Consider the following equation:
Pretain = Pcum ×
The term Pretain in this equation represents:
A) the price of the stock if it retains and invests the cash.
B) the percentage of net income retained or reinvested back into the firm.
C) the percentage of net income paid out as a cash dividend.
D) the price of the stock if it retains cash to use in a share repurchase.
10) Consider the following equation:
Pretain = Pcum ×
The term τc in this equation represents:
A) the corporation’s tax rate on interest income.
B) the investor’s tax rate on interest income.
C) the investor’s tax rate on cumulative dividends.
D) the investor’s tax rate on capital gains.
Use the information for the question(s) below.
Luther Industries has $5 million in excess cash and 1 million shares outstanding. Luther is considering
investing the cash in one-year treasury bills that are currently paying 5% interest, and then using the
cash to pay a dividend next year. Alternatively, Luther can pay the cash out as a dividend immediately
and the shareholders can invest in the treasury bills themselves. Assume that capital markets are
perfect.
11) If Luther invests the excess cash in treasury bills, then the dividend per share next year will be
closest to:
A) $5.00
B) $5.25
C) $4.75
D) $1.05
12) If Luther decides to pay the dividend immediately the dividend per share will be closest to:
A) $1.05
B) $5.25
C) $5.00
D) $4.75
13) In 2006, Luther Incorporated paid a special dividend of $5 per share for the 100 million shares
outstanding. If Luther has instead retained that cash permanently and invested it into treasury bills
earning 5%, then the present value of the additional taxes paid by Luther would be closest to:
A) $35 million
B) $290 million
C) $175 million
D) $585 million
Use the information for the question(s) below.
Consider the following tax rates:
Year
Corporate
Tax Rate
Capital
Gains
Rate
Ordinary
Income Rate
Dividend
Rate
1997-2000
35%
20%
40%
40%
2001-2002
35%
20%
39%
39%
2003–
35%
15%
35%
15%
14) The effective tax disadvantage for retaining cash in 2006 is closest to:
A) 14.75%
B) 12.50%
C) 35.00%
D) 15.00%
15) The effective tax disadvantage for retaining cash in 2002 is closest to:
A) 15.00%
B) 14.75%
C) 30.00%
D) 35.00%
16) The effective tax disadvantage for retaining cash in 2000 is closest to:
A) 15.00%
B) 13.35%
C) 14.75%
D) 35.00%
Use the information for the question(s) below.
Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200 million in cash
and expects future free cash flows of $75 million per year. Management plans to use the cash to expand
the firm’s operations, which in turn will increase future free cash flows by 12%. Iota’s cost of capital is
10% and assume that capital markets are perfect.
17) The value of Iota if they use the $200 million to expand is closest to:
A) $825 million
B) $688 million
C) $840 million
D) $950 million
18) The value of Iota if they do not use the $200 million to expand and hold the cash instead is closest to:
A) $840 million
B) $825 million
C) $950 million
D) $688 million
19) The price per share of Iota if they use the $200 million to expand is closest to:
A) $13.75
B) $16.50
C) $19.00
D) $16.80
20) The price per share of Iota if they decide not to use the $200 million to expand and hold the cash
instead is closest to:
A) $16.50
B) $16.80
C) $19.00
D) $13.75