After completing its capital spending for the year, Carlson Manufacturing has $1,000 extra cash. Carlson’s managers must choose between investing the cash in Treasury bonds that yield 8 percent or paying the cash out to investors who would invest in the bonds themselves.
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If the corporate tax rate is 35 percent, what personal tax rate would make the investors equally willing to receive the dividend or to let Carlson invest the money?
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Is the answer to (a) reasonable? Why or why not?
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Suppose the only investment choice is a preferred stock that yields 12 percent. The corporate dividend exclusion of 70 percent applies. What personal tax rate will make the stockholders indifferent to the outcome of Carlson’s dividend decision?
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Is this a compelling argument for a low dividend payout ratio? Why or why not?