Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 40 percent of their salary for five years. For purposes of this problem, ignore payroll taxes in your computations

a. Assume XYZ has a marginal tax rate of 21 percent for the foreseeable future and earns an after-tax rate of return of 12 percent on its assets. Joel Johnson, XYZ’s VP of finance, is attempting to determine what amount of deferred compensation XYZ should be willing to pay in five years that would make XYZ indifferent between paying the current salary of $12,900 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective?

b. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 37 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $12,900 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 6 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

Deferred compensation :

b. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 37 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $12,900 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 6 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

Deferred compensation :

     

Answer 1

a.

$22734. If XYZ were to pay $12900, its after-tax cost would be $10191[$12900 × (1 –.21)].If it defers the compensation it would save $10191 after-taxes.This is equivalent to $17960 after-taxes in 5 years ($10191× 1.125).So, XYZ should be indifferent between paying Joel $10191 after-taxes now or$17960 after taxes in 5 years.Assuming XYZ’s marginal tax rate remains at 21%, $17960 after-taxes is $22734 before-taxes [$17960/(1 –.21)].

b.

$17263.If Julie were to take the salary now she would receive $8127 after tax (12900 × (1 – .37)). She would then invest this amount in taxable corporate bonds.After five years Julie would have accumulated $10876 after taxes by taking the salary and investing it herself [(8127 × 1.065].Thus, in order to be indifferent after five years between the salary and deferred compensation, she must receive enough deferred compensation to provide her with $10876 after she pays tax at her 37% marginal tax rate.If she receives $17263, she will have$10876 after taxes [$10876/ (1-.37)].