Palomino Enterprises has generated profits of $300,000 before tax. They wish to invest the money in Treasury bonds at 8% and use the returns to pay dividends to shareholders after a year. Alternately, they can pay a dividend and allow shareholders to make the investment. If corporate tax rates are 30%, which option would be preferred by shareholders paying a marginal tax rate of 45%?

Question

Quizplus · Accepted Answer

If the company pays a dividend after one year, the shareholders will pay 45% tax on the dividend. However, if the company invests the money in Treasury bonds, the shareholders will only pay 30% tax on the interest income. Therefore, the shareholders would prefer the company to invest the money in Treasury bonds and pay a dividend after one year.

Palomino Enterprises Has Generated Profits of $300,000 Before Tax