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personal finace

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.

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