Palo Alto Enterprises has $100,000 in cash. They wish to invest the money in Treasury bills at 6% and use the returns to pay dividends to shareholders after a year. Alternatively they can pay a dividend and allow shareholders to make the investment. If corporate tax rates are 35%, which option will shareholders prefer?

Question

Quizplus · Accepted Answer

The shareholders would prefer an immediate cash dividend because the corporate tax on the investment returns would reduce the amount available for dividends. If the company invests and pays after a year, the returns would be subject to a 35% corporate tax, reducing the amount shareholders receive. If shareholders receive the dividend immediately, they can invest the amount themselves and potentially avoid the corporate tax, assuming their personal tax situation is more favorable.

Palo Alto Enterprises Has $100,000 in Cash