After completing its capital spending for the year, Carlson Manufacturing has $1,000 extra cash. Carlson’s managers must choose between investing the cash in Treasury bonds that yield 3.5 percent or paying the cash out to investors who would invest in the bonds themselves.
a. If the corporate tax rate is 35 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money?
b. Is the answer to (a) reasonable? Why or why not?
c. Suppose the only investment choice is a preferred stock that yields 6.2 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of Carlson’s dividend decision?
d. Is this a compelling argument for a low dividend-payout ratio? Why or why not?