Question

Elizabeth, an individual taxpayer, has a marginal tax rate on ordinary income of 32% and a tax rate on long-term capital gains of 15%. She has $100,000 that she wants to invest for the next 6 months, at which time she will liquidate the investment. She is considering three investment alternatives: (1) a corporate bond yielding an annual interest rate of 5%; (2) a municipal bond that pays and annual interest rate of 3%; (3) stock that will pay a dividend of $1000 and is expected to increase in value by 2% per year. Assume that Elizabeth can purchase the stock after the declaration date but before the record date, and that all interest and dividends will be received at the end of the 6 month period. Which investment alternative should Elizabeth choose? Please show your calculations.
a. After-tax return for corporate bond_____________.
b. After-tax return for municipal bond___________.
c. After-tax return for stock__________
d. Which investment should Elizabeth choose?____________.

Answer 1

Answer:

a. After-tax return for corporate bond $1,700.

b. After-tax return for municipal bond = $1,500.

c. After-tax return for Stock = $1,320

d. Which investment should Elizabeth choose?Corporate Bonds .

Explanation:

The question is to calculate a few figures and the steps are detailed below

1)The After tax Return for the Corporate Bond

Interest and dividend is received at the end of 6 months period

Therefore: The interest = 6/12 x 100,000 x 5%) = $2,500

Secondly subtract tax from the interest= 32% of $2,500 = 800

therefore, Interest after tax = $2,500-$800 = $1.700

2)Calculate the After tax return on Municipal bonds

First, the interest on the municipal bonds =

6/12 x $100,000 x 3% = $1,500

Since municipal bonds interests are tax exempt. The amount remains

3) Determine the after tax return on stock

First, the dividend = $1,000 subtract tax (0.32 x 1,000)

= $1,000-$320 = $680

Secondly, since the capital appreciation on the stock is to be computed as follows:

6/12 x $100,000 x 2% = $1,000

subtract tax (0.32 x 1,000)

= $1,000-$320 = $680 (this is the net appreciation)

This means that net tax return on stock is 680 + 680 = $1,320

This is based on the assumption of stock sales at the end of the 6th month leading to the use of a marginal tax rate.

D) Elizabeth would be advised to invest in the asset with the highest after tax return which is the corporate bond