Question

Pratt is ready to graduate and leave College Park. His future employer (Ferndale Corp.) offers the following four compensation packages from which Pratt may choose. Pratt will start working for Ferndale on January 1, year 1. Benefit Description Option 1 Option 2 Option 3 Option 4 Salary $ 60,000 $ 50,000 $ 45,000 $ 45,000 Health insurance No coverage $ 5,000 $ 5,000 $ 5,000 Restricted stock 0 0 1,000 shares 0 NQO's 0 0 0 100 options Assume that the restricted stock is 1,000 shares that trade at $5 per share on the grant date (January 1, year 1); shares are expected to be worth $10 per share on the vesting date at the end of year 1; and no 83(b) election is made. Assume that the NQOs (100 options) each allows the employee to purchase 10 shares at $5 exercise price. The stock trades at $5 per share on the grant date (January 1, year 1) and is expected to be worth $10 per share on the vesting date at the end of year 1, and the options are exercised and sold at the end of the year. Also assume that Pratt spends on average $3,000 on health-related costs that will be covered by insurance if he had coverage or is an after-tax expense if he isn't covered by insurance (treat this as a cash outflow). Assume that Pratt’s marginal tax rate is 35 percent. (Ignore FICA taxes and time value of money considerations). What is the after-tax value of each compensation package for year 1? If Pratt’s sole consideration is maximizing after-tax value for year 1, which scheme should he select?

Answer 1

Answer:

A. Option 1 After-tax value Compensation Package $36,000

Option 2 After-tax value Compensation Package $32,500

Option 3 After-tax value Compensation Package $35,750

Option 4 After-tax value Compensation Package $35,750

B. Option 1

Explanation:

Calculation to determine the after-tax value of each compensation package for year 1

OPTION 1 COMPENSATION PACKAGE

Salary $60,000

Add Restricted Stock$0

Taxable Total $60,000

($60,000+$0)

Tax Rate 35%

Less Tax Paid ($21,000)

($60,000*35%=$21,000)

After-tax cash value$39,000

($60,000-$21,000)

NQO’s$0

Less Health care expenses ($3,000)

After-tax value $36,000

($39,000-$3,000)

Therefore Option 1 After-tax value Compensation Package is $36,000

OPTION 2 COMPENSATION PACKAGE

Salary $50,000

Add Restricted Stock$0

Taxable Total $50,000

($50,000+$0)

Tax Rate 35%

Less Tax Paid ($17,500)

(35%*$50,000=$17,500)

After-tax cash value $32,500

($50,000-$17,500)

NQO’s$0

Less Health care expenses ($0)

After-tax value $32,500

($32,500-$0)

Therefore Option 2 After-tax value Compensation Package is $32,500

OPTION 3 COMPENSATION PACKAGE

Salary $45,000

Restricted Stock$ 10,000

Taxable Total $55,000

($45,000+$10,000)

Tax Rate 35%

Less Tax Paid ($19,250)

($35%*$55,000)

After-tax cash value$35,750

($55,000-$19,250)

NQO’s$0

Less Health care expenses ($0)

After-tax value $35,750

($35,750-$0)

Therefore Option 3 After-tax value Compensation Package is $35,750

OPTION 4 COMPENSATION PACKAGE

Salary $45,000

NQO’s $10,000

Taxable Total $55,000

($45,000+$10,000)

Tax Rate 35%

Less Tax Paid ($19,250)

($55,000*35%)

After-tax cash value $35,750

($55,000-$19,250)

Less Health care expenses ($0)

After-tax value $35,750

($35,750-$0)

Therefore Option 4 After-tax value Compensation Package is $35,750

b. Based on the above calculation assuming his sole consideration is maximizing after-tax value for year 1, the scheme that he should select is OPTION 1 with the amount of $36,000 reason been that OPTION 1 tend to maximizes after-tax value for year 1.