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Luther Industries has $5 million in excess cash and 1 million shares outstanding.Luther is considering investing the cash in one-year treasury bills that are currently paying 5% interest,and then using the cash to pay a dividend next year.Alternatively,Luther can pay the cash out as a dividend immediately and the shareholders can invest in the treasury bills themselves.Assume that capital markets are perfect.
-If Luther invests the excess cash in treasury bills,then the dividend per share next year will be closest to:
A)$5.00.
B)$5.25.
C)$4.75.
D)$1.05.

Question

Quizplus · Accepted Answer

If Luther Industries invests the excess cash in 1-year treasury bills at 5% interest, the investment will grow to $5.25 million ($5 million x 1.05) at the end of one year. If Luther Industries uses this money to pay dividends, the dividend per share will be $5.25 per share ($5.25 million / 1 million shares).

Option B is the best choice as it will result in the highest dividend per share for the shareholders. If the shareholders were to invest the dividend themselves in treasury bills at 5%, they would end up with the same $5.25 per share dividend, but the company investing the excess cash will eliminate any transaction costs that the shareholders would incur in investing the dividend themselves.

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