Bernie and Pam Britten are a young married couple beginning careers and establishing a household. They will each make about $50,000 next year and will have accumulated about $40,000 to invest. They now rent an apartment but are considering purchasing a condominium for $100,000. If they do, a down payment of $10,000 will be required.
They have discussed their situation with Lew McCarthy, an investment advisor and personal friend, and he has recommended the following investments:
The condominium - expected annual increase in market value = 5%.
Municipal bonds - expected annual yield = 5%.
High-yield corporate stocks - expected dividend yield = 8%.
Savings account in a commercial bank-expected annual yield = 3%.
High-growth common stocks - expected annual increase in market value = 10%; expected dividend yield = 0.
Calculate the after-tax yields on the foregoing investments, assuming the Brittens have a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief Reconciliation Act of 2003).
How would you recommend the Brittens invest their $40,000? Explain your answ
Three major factors come into play when making investment decisions; 1) after-tax rate of return, 2) Risk, 3) Liquidity. (Liquidity reflects the speed and ability to turn a asset into cash).
Calculate the after-tax rate of return as the rate of return times 1 less the appropriate marginal tax rate. That is ATR=r*(1-t). The current Federal marginal tax rate on capital gains and dividends for the Brittens is 15%. The tax on the gains from the condo can safely assumed to be zero.
So, rates of after tax rates of return:
Condo = 5% (Less if the Brittons itemize their deductions and can deduct their interest expenses).
Munis = 5%
Dividend paying stocks = 8%*(.85)
Saving accounts = 3%*(.72)
Growth stocks = 10%*(.85)
Investment risks
Condo -- medium risk
Munis -- low risk,
Dividend Stocks -- medium-high
Savings accounts -- zero
Growth stocks -- high
Liquidity is best with the savings account. Next are stocks. Munis are generally the same as or worse than stocks. Poorest liquidity is the condo.
Assuming the Britton's current rent is not dirt cheap, and assuming Brittons are not planning to relocate in the near future, the clear winner is buying the Condo with $10,000 down.
The clear loser is the Muni bonds. In my opinion, the lower risk does compensate for the lowest after-tax rate of return.
Mix the other three according to the Britten's stomach for risk and their need for ready cash.
I forgot to add, tax on growth stocks are deferred to the future. So, the after tax rate of return should reflect, in principal, some present-value discounting and expected holding period.
Based on the information provided, here is the recommendation for how the Brittens should invest their $40,000:
1. Condominium: Since the expected annual increase in market value is 5% and the Brittons are not likely to be taxed on the gains from the condo, they can expect a 5% after-tax rate of return. However, it is important to note that there may be additional expenses such as property taxes and maintenance costs associated with owning a condo.
2. Municipal bonds: The expected annual yield on municipal bonds is 5%. Since the Brittons' marginal tax rate is 28%, the after-tax rate of return would be 5% * (1 - 0.28) = 3.6%.
3. High-yield corporate stocks: The expected dividend yield on high-yield corporate stocks is 8%. After accounting for the 15% tax rate on dividends, the after-tax rate of return would be 8% * (1 - 0.15) = 6.8%.
4. Savings account in a commercial bank: The expected annual yield on a savings account is 3%. After applying the 28% tax rate, the after-tax rate of return would be 3% * (1 - 0.28) = 2.16%.
5. High-growth common stocks: The expected annual increase in market value for high-growth common stocks is 10%. However, since there is no expected dividend yield, the after-tax rate of return would be 10% * (1 - 0.15) = 8.5%.
Considering the Brittons' situation, it is recommended to allocate a portion of their $40,000 towards the down payment on a condominium. The remaining amount can be diversified across other investments based on their risk tolerance and need for liquidity.
The condo investment provides potential appreciation in market value and serves as a long-term investment. Municipal bonds provide low-risk returns but have the lowest after-tax rate of return. Dividend-paying stocks offer a relatively higher after-tax rate of return. Savings accounts provide low risk and high liquidity but have the lowest after-tax rate of return. High-growth common stocks offer the highest expected after-tax rate of return but also come with higher risk.
Ultimately, the investment decision should be based on the Brittens' financial goals, risk tolerance, and time horizon. It is advisable to consult with a financial advisor to create a personalized investment plan based on their specific circumstances.