Bernie and Pam Britten together earn $100,000 a year. They have $40,000 to invest they are considering buying a condo for $100,000 with a required $10,000 down payment. Their friend has recommended the following investments
the condo-expected annual increase in market value= 5%
Municipal bonds- expected to annual yield = 5%
High-yield corporate stocks-expected dividend yield = 8%
Saving account in a commerical bank-expected annual yield = 3%
High growth common stock-expected annual increase in market value = 10%; expected dividend yield = 0
Calculate the after tax yield on the foregoing investments assuming the Britten's have a 28% marginal tax rate (based on the Public Law 108-27, The Jobs and Growth Tax Relief Reconcilation Act of 2003)
How would you recommend the Britten's invest their $40,000. Explain
To calculate the after-tax yield on the investments, we need to consider the tax implications for each option.
Let's analyze each investment and calculate their after-tax yields:
1. Condo:
The expected annual increase in the market value is 5%. Since this is not an income-generating investment, there are no dividends or interest to be taxed. Therefore, there is no need to calculate the after-tax yield for this investment.
2. Municipal Bonds:
The expected annual yield is 5%. Municipal bond interest is typically exempt from federal income tax. Therefore, the after-tax yield for municipal bonds is the same as the expected annual yield, which is 5%.
3. High-Yield Corporate Stocks:
The expected dividend yield is 8%. Dividends from high-yield corporate stocks are subject to tax. Since the Britten's have a 28% marginal tax rate, we need to calculate the after-tax yield. To do so, we multiply the dividend yield by (1 - tax rate).
After-tax yield = 8% * (1 - 0.28) = 5.76%
4. Savings Account in a Commercial Bank:
The expected annual yield is 3%. Similar to the municipal bonds, the interest earned from a savings account is subject to federal income tax. Therefore, the after-tax yield is calculated by multiplying the yield by (1 - tax rate).
After-tax yield = 3% * (1 - 0.28) = 2.16%
5. High Growth Common Stock:
The expected annual increase in the market value is 10%, and there is no expected dividend yield. Since this investment doesn't generate any income, there is no tax implication for dividends. Therefore, we only need to consider the tax implication on the capital gains when the stock is sold. However, as this information is not provided, we cannot calculate the after-tax yield for this investment.
Now let's compare the after-tax yields:
- Condo: No need to calculate after-tax yield.
- Municipal Bonds: After-tax yield = 5%
- High-Yield Corporate Stocks: After-tax yield = 5.76%
- Savings Account: After-tax yield = 2.16%
- High Growth Common Stock: Not enough information to calculate after-tax yield.
Based on the available information, it appears that the high-yield corporate stocks have the highest after-tax yield at 5.76%. Therefore, I would recommend investing the $40,000 in high-yield corporate stocks, given their higher after-tax yield compared to the other options. Nonetheless, it's important to consider the risks associated with this type of investment, as high-yield corporate stocks can be more volatile than other options. It's always a good idea to diversify your investments to minimize risk. Consulting with a financial advisor would be beneficial in making the best decision for the Britten's specific financial situation.
To calculate the after-tax yield on each investment option, we will need to consider the impact of the Britten's marginal tax rate of 28%.
1. Condo investment:
- Required down payment: $10,000
- Mortgage loan: $100,000 - $10,000 = $90,000
- Expected annual increase in market value: 5%
There are no immediate tax implications or yield from this investment, as it solely relies on the potential increase in market value over time.
2. Municipal bonds:
- Expected annual yield: 5%
Municipal bond interest is generally exempt from federal taxes, and since the Britten's have a marginal tax rate of 28%, the after-tax yield on municipal bonds can be calculated as:
After-tax yield = Expected annual yield * (1 - Marginal tax rate)
After-tax yield = 5% * (1 - 0.28)
After-tax yield = 5% * 0.72
After-tax yield = 3.6%
3. High-yield corporate stocks:
- Expected dividend yield: 8%
Dividends from high-yield corporate stocks are subject to taxes. Using the same calculation as above, the after-tax yield on high-yield corporate stocks would be:
After-tax yield = Expected dividend yield * (1 - Marginal tax rate)
After-tax yield = 8% * (1 - 0.28)
After-tax yield = 8% * 0.72
After-tax yield = 5.76%
4. Savings account in a commercial bank:
- Expected annual yield: 3%
The interest earned on a savings account is also subject to taxes, so the after-tax yield would be calculated in the same manner:
After-tax yield = Expected annual yield * (1 - Marginal tax rate)
After-tax yield = 3% * (1 - 0.28)
After-tax yield = 3% * 0.72
After-tax yield = 2.16%
5. High growth common stock:
- Expected annual increase in market value: 10%
- Expected dividend yield: 0
Similar to the condo investment, there are no immediate tax implications or yield from this investment, as it depends solely on the potential increase in market value over time.
Based on the after-tax yields calculated above, the Britten's should consider investing their $40,000 as follows:
- Allocate $10,000 for the down payment on the condo.
- Invest $10,000 in municipal bonds for an after-tax yield of 3.6%.
- Invest $10,000 in high-yield corporate stocks for an after-tax yield of 5.76%.
- Place $10,000 in a savings account in a commercial bank for an after-tax yield of 2.16%.
By diversifying their investments across different asset classes, the Britten's can potentially benefit from growth in the condo's market value, the income generated from municipal bonds and high-yield corporate stocks, and the stability of a savings account.