The ABC Company could pay out all of its earnings as dividends; however, it wants to choose between a policy of paying out dividends as the income is earned (now and for the next three years) or alternatively reinvesting all of its earnings and paying one dividend three years from now. With no additional retained earnings, the firm can maintain a dividend of $100 per share.

Stockholders can earn 0.10 by investing any dividends received. These earnings are subject to tax.

Assume that capital gains and ordinary income are both taxed at a rate of 0.6.

a. ABC has many one-period investments that yield 0.08. Should the firm invest or pay a current dividend? Find the future value of stockholders’ wealth three years from now.

b. How low a yield can an investment have and still be acceptable to the firm?

c. Assume the firm has investments yielding 0.10. What is the improvement in value arising from retaining for one year compared with a $100 dividend?