Subject Tax Accounting Maurice is currently considering investing in a high divi
ID: 2333526 • Letter: S
Question
Subject Tax Accounting
Maurice is currently considering investing in a high dividend yield stock with no growth potential that pays a 6% dividend yield or bonds issued by The Coca Cola company that pay 8%.If Maurice's ordinary tax rate is 25% and his dividend tax rate is 15%, which investment should he choose? Which investment should he choose if his ordinary tax rate is 30%. At what ordinary tax rate wouls he be indifferent to the stock or to the bond? What strategy is this decision based upon?
Explanation / Answer
1..Assuming same amount of money invested in both stock or bond After-tax return on stock=6%*(1-15%)= 5.10% After-tax return on Coca Cola Bonds=8%*(1-25%)= 6.00% He should choose the Coca Cola bond for it returns the greater after-tax return 2.If his ordinary tax rate is 30% After-tax return on stock=6%*(1-15%)= 5.10% After-tax return on Coca Cola Bonds=8%*(1-30%)= 5.60% He should still choose the Coca Cola bond for it returns the greater after-tax return 3..Ordinary tax rate at which he will be be indifferent to the stock or to the bond is the tax rate at which the after-tax income will be the same. so, equating both the after-tax rates, 6%(1-15%)=8%*(1-x%) solving the above , the indifferent ordinary tax rate =x= 36.25% Indifference strategy -ie. When his ordinary tax rate is 36.25%, he will be indifferent between investing in this stock or Coca Cola bonds, as his after-tax income will be the same under both. In any case, it needs to be remebered that stock-dividends are more volatile compared to bond- interests as the latter is assured & constant over the life of the bond, whereas stock prices keep changing & dividend amounts are not that certain.