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Question - KMS Corporation faces a choice betweenpaying out $300 million cash through a share repurchase, and investing the $300 million in Treasury securities paying 6% interest for one year.
If shareholders are paid the cash through a share repurchase, they are going to invest it in the same T-securities as KMS would. If KMS retains and invests cash it is going to pay the entire investment income out to shareholders in the form of dividends
Assume that corporate tax rate is 35% and investors pay 15% tax rate on dividends and capital gains and 30% on interest income.
1. What would shareholders want KMS to do with the cash? Explain, provide computations.
2. Now suppose that KMS plans an expansion project next year. If the company retains the cash it would not need to raise new funds from outside investors for the project. Raising new funds costs F dollars, nominal issuance fees. The fees expense is tax deductible. If the amount F is $ 3 million, what would be optimal for KMS to do - retain cash or pay it out and raise cash in one year when it needs cash for the project?
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