Assume that you are in the 40% federal-plus-state marginal tax bracket and that
ID: 2818370 • Letter: A
Question
Assume that you are in the 40% federal-plus-state marginal tax bracket and that capital gains taxes are deferred until maturity. Assuming equal investment risk and a horizontal yield curve, rank the following investment opportunities on the basis of the effective annual yields:
a. A $100 par value perpetual preferred stock with an annual coupon of 12%, quarterly payments, and selling at $105.
b. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 12% currently selling at $1,050.
c. A $1,000 par value, 20-year, non callable, semiannual bond with a coupon of 6% selling at a price of $637.
d.How would the situation change if the ranker had been:
1)a pension fund investment manager or
2)a corporation that is in the 40% federal-plus-state bracket?
Part d - Explain in words but demonstrate that you could quantify your answer.
Explanation / Answer
3.10%
Effective Annual Yield % = Effective rate × (1-tax rate on stock)
Prefered stock> non callable semi annual bond with a coupon of 12%> non callable semiannual bond with a coupon of 6%.
I would choose a over b over c. I would choose the preferred stock over non callable semi annual bond with a coupon of 12% over the non callable semiannual bond with a coupon of 6%.
D.
1. a. For a pension fund investment manager there will be no difference with an individual because the capital gain taxes are deferred until maturity. Pension funds are usually exempt from tax. For the pension fund manager, the tax payable will be inapplicable and not a measure taken into consideration in the computation of the effective annual rate.
2. a. For a corporation it has more incentive to buy low yielding stocks than high yielding bonds so we should consider reduced taxation. Corporations are meant to bear the full brunt of tax. For the corporation, the effective annual rate will be influenced by the tax rate since intrest costs are fully deductible from income.
The difference between a pension fund manager' ranking and a corporation's ranking involve the possibility of avoiding tax.
The ranking will be same for both pension managers and the corporation.
Part Stock Par Value Coupon rate Selling Price Normalised rate Effective rate Tx rate on stock Effective annual yield a Preferred stock $100 12% $105 11.42% 11.93% 20% 9.54% b Non callable $1000 6% $1050 5.71% 5.68% 40% 3.41% c No callable $1000 3% $637 4.71% 5.16% 40%3.10%