Problem - Assume capital markets are perfect. Kay Industries currently has $ 150 million invested in short-term Treasury securities paying 7 %, and it pays out the interest payments on these securities as a dividend. The board is considering selling the Treasury securities and paying out the proceeds as a one-time dividend payment. Assume investors pay a 15 % tax on dividends and capital gains, and a 40 % tax on interest income, while Kay pays a 40 % corporate tax rate.
a. If the board went ahead with this plan, what would happen to the value of Kay stock upon the announcement of a change in policy? If the board went ahead with this plan, the equity value of Kay would go (up/down) by $____ million on announcement.
b. What would happen to the value of Kay stock on the ex-dividend date of the one-time dividend? Which selection?
(a) The value of Kay would rise by $150 million.
(b) The value of Kay would fall by $150 - $150 x 15% = $127.5 million.
(c) The value of Kay would fall by $150 million.
(d) The value of Kay would remain the same.
c. Given these price reactions, will this decision benefit investors? Which selection?
(a) It will neither benefit nor hurt investors.
(b) It will benefit investors.
(c) It will hurt investors.
(d) It is difficult to tell because the price reaction depends on investor preferences.