Assume that the only capital market imperfection is taxes. 

KayKay 

Industries currently has 

$ 100$100 

million invested in​ short-term Treasury securities paying 

7 % comma7%, 

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 that 

KayKay 

must pay a corporate tax rate of 

21 %21%​,

 investors pay no​ taxes, and there is no taxable gain from the sale of the securities.

**a.** If the board went ahead with this​ plan, what would happen to the value of 

KayKay 

stock upon the announcement of a change in​ policy?

**b.** What would happen to the value of 

KayKay 

stock on the​ ex-dividend date of the​ one-time dividend?

**c.** Given these price​ reactions, will this decision benefit​ investors?

Question content area bottom

Part 1

**a.** If the board went ahead with this​ plan, what would happen to the value of 

KayKay 

stock upon the announcement of a change in​ policy? ** ​(Select the best choice​ below.)

A.

The value of 

KayKay 

would remain the same.

B.

The value of 

KayKay 

would rise by 

$ 100$100 

million.

C.

The value of 

KayKay 

would rise by 

$ 100 million times 0.21 equals $ 21 million$100 million×0.21=$21 million.

D.

The value of 

KayKay 

would fall by 

$ 100$100 

million.

To analyze the question correctly, let’s break down each part, considering the capital market imperfections (taxes) and the financial impact of the board's proposed plan.

### **Part a**: What happens to KayKay stock upon the announcement of the change in policy?

KayKay currently holds $100 million in short-term Treasury securities that generate interest income. The key issue here is that KayKay pays a **corporate tax rate of 21%** on this interest income. The interest payments are currently being paid as a dividend, but with taxes eating into the profits.

If the company sells the Treasury securities and pays out a **one-time dividend**, this changes the company’s strategy and dividend payout pattern, but no actual change in corporate value happens just due to the announcement. The reason is that this change does not affect the overall wealth of the shareholders or the company’s assets (assuming no transaction costs or other capital market imperfections beyond taxes).

#### **Answer**: **A. The value of KayKay would remain the same.**

Upon the announcement, there is no immediate change to the firm’s value because it's just a shift in how the firm’s assets are managed and paid out to shareholders.

---

### **Part b**: What happens to the value of KayKay stock on the ex-dividend date?

On the **ex-dividend date** of a **one-time dividend** equal to the proceeds of $100 million, the company will distribute its cash reserves to shareholders. Since the company will be left with $100 million less in cash, the stock price will adjust downward by the dividend amount.

In this case, the stock price would decrease by the amount of the **one-time dividend**, which is the $100 million being paid out.

#### **Answer**: The value of KayKay stock will fall by **$100 million** on the ex-dividend date. The drop corresponds to the total value of the dividend being distributed to shareholders.

---

### **Part c**: Will this decision benefit investors?

To assess whether investors benefit, we need to compare the effects before and after the dividend is paid. The company’s stock price will fall by the amount of the dividend, but shareholders will receive the cash payout in exchange.

Since investors **pay no taxes**, they receive the full value of the dividend. Meanwhile, keeping the Treasury securities would result in tax leakage, as 21% of the interest would be lost to corporate taxes each year.

By distributing the $100 million as a one-time dividend, the firm avoids the future tax payments on interest income. Thus, shareholders get the full $100 million immediately, rather than waiting for smaller, taxed interest payments in the future.

#### Conclusion: **Yes**, this decision will benefit investors because they will receive the full $100 million without suffering the 21% tax burden that would have been incurred through continued interest payments.

---

### Summary:
- **a.** The value of KayKay would remain the same upon the announcement.
- **b.** The value of KayKay stock will fall by $100 million on the ex-dividend date.
- **c.** This decision will benefit investors as they avoid future corporate taxes on interest income.

---

Would you like any more details on this explanation?

Here are 5 follow-up questions:
1. How does the corporate tax rate affect a company's decision to pay dividends versus retaining earnings?
2. How does the ex-dividend date impact investors who buy stock just before the dividend is paid?
3. Can stock buybacks be a better alternative to one-time dividends from a tax perspective?
4. How does the timing of dividend payments affect shareholder value?
5. What are the implications of having no taxes on investors in this scenario?

**Tip**: When evaluating dividend policies, always consider how corporate taxes and dividend taxes (if any) affect the overall wealth transfer to shareholders.

Assume that the only capital market imperfection is taxes. KayKay Industries currently has $100 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 that KayKay must pay a corporate tax rate of 21%, investors pay no taxes, and there is no taxable gain from the sale of the securities. a. If the board went ahead with this plan, what would happen to the value of KayKay stock upon the announcement of a change in policy? b. What would happen to the value of KayKay stock on the ex-dividend date of the one-time dividend? c. Given these price reactions, will this decision benefit investors?

Explore how a one-time dividend payout from KayKay Industries affects stock value, factoring in a corporate tax rate of 21%. Understand the financial dynamics of ex-dividend dates and the benefits to investors in this corporate finance problem. Suitable for finance students and professionals.

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