Deck 21: Tax Aspects of Corporate Financing

Question 1

Mary is deciding where to invest $10,000. Based on her decision, she will either receive a 5% capital gain or a 7% non-eligible dividend as her return on investment. Mary's marginal tax rates are: 45% on regular income, 36% on non-eligible dividends, 28% on eligible dividends, and 23% (rounded) on capital gains. Which of the following is
TRUE?

A) Mary will receive an after-tax rate of return of 3.85% on the capital gain and 4.48% on the non-eligible dividends.
B) Mary will receive a higher after-tax rate of return on the capital gain due to the higher tax rate for non-eligible dividends.
C) Mary will receive an after-tax rate of return of 5% on the capital gain and 7% on the non-eligible dividends.
D) There is no difference in the after-tax rate of return on the two investments.

Answer 1

A

Question 2

Silver Photo Studios Inc. (SPS) requires $50,000 capital for a proposed
expansion. Simon Silver, the company's president and CEO is trying to decide whether to issue preferred shares with a fixed dividend rate of 5%, or to borrow from the bank at a rate of 7%. SPS pays a corporate tax rate of 15%.
Required:

A) Determine the amount of corporate income that would be required to finance each of the alternative funding methods.
B) Calculate the actual cost (as a %) of the debt and the actual cost (as a %) of issuing the preferred shares.

Answer 2

A) Corporate income of $3,500 ($50,000 × 7%) is required to finance the interest on the bank loan.
Corporate income of $2,941 ($50,000 × 5%)/(1 - .15) is required to finance the dividends on the preferred shares.
B) The cost of the 7% debt is 7%. (3,500/50,000) The cost of the 5% dividend is 5.9%. (2,941/50,000)

Question 3

With regard to debt securities, which of the following statements is TRUE?

A) Issuing debt securities at a premium will normally increase the after-tax cost of financing for the issuer, provided they are not in the business of lending money.
B) Issuing debt securities at a premium results in the borrowing corporation receiving funds below the stated price.
C) Issuing debt securities at a premium will normally reduce the after-tax cost of financing for the issuer, provided they are not in the business of lending money.
D) Issuing debt securities at a premium is not allowed for tax purposes.

Answer 3

C

Question 4

Andrea Houser recently inherited $500,000. She would like to invest the money and receive an after-tax return of $30,000 on the investment income. She has a number of investment alternatives available to her and she would pay 45% tax on interest, 28% tax on eligible dividends, 36% tax on non-eligible dividends, and 23% (rounded) on capital gains.
Required:
Calculate how much taxable income Andrea would need to receive in a) interest,
b) eligible dividends, c) non-eligible dividends, and d) capital gains in order to realize a $30,000 after-tax return. (Round all answers to zero decimal points.)

Question 5

Which of the following statements regarding preferred share financing is FALSE?

A) Preferred share dividend payments are non-deductible.
B) The preferred share issue may be structured so as to enhance the after-tax return of investors.
C) Current tax laws simplify the nature of preferred share financing for corporations.
D) There is a special tax on preferred dividends in excess of $500,000 annually, even if the issuing corporation has no taxable income.

Question 6

During the year, The Light Corporation paid $550,000 in preferred share dividends to ABC Inc. Both companies are Canadian corporations. Which of the following is TRUE?

A) The Light Corporation will have to pay Part VI.1 tax on the dividend, regardless of whether or not it has taxable income.
B) ABC Inc. will have to pay Part VI.1 tax on the dividend, regardless of whether or not it has taxable income.
C) ABC Inc. will have to pay Part VI.1 tax on the dividend, only if it has taxable income.
D) The Light Corporation will have to pay Part VI.1 tax on the dividend, only if it has taxable income.

Question 7

Joe Genius of ABC Corporation is considering whether to lease or purchase a large capital asset. If Joe purchases the asset, he will use debt financing. Which of the following accurately describes the similarities in the tax treatment of leasing and purchasing with debt?

A) Both methods allow for a tax deduction.
B) Capital cost allowance is always calculated for both alternatives.
C) Cash payments and tax savings will usually occur simultaneously for both alternatives.
D) Principal payments are deductible for both alternatives.

Question 8

Jet Dry Inc. is undergoing a sale/leaseback arrangement on a piece of its
excavating equipment. The equipment (Class 38 - 30%) has a fair market value of $250,000, and currently generates $75,000 in annual revenue.
Under the leasing terms, the lease agreement will be for five years, with no
residual value at the end of the term. The annual leasing cost will be $55,000 per year.
The current UCC of the equipment is $150,000. Other assets will remain in the asset pool, and recapture will not occur as a result of the sale.
The company is subject to a corporate tax rate of 27% and achieves a 12% after-tax rate of return.
Required:
Calculate the net present value of the cash flow that will result from this
sale-and-leaseback arrangement. (Round all numbers to zero decimal points.)