Question

(show all workings 60 marks)

This question relates to material covered in Topics 1-5. This question addresses the 1st, 2nd and 3rd subject learning outcomes.

(a) Bradley hates taking risk with his money; "I hate shares and property, I know a lot of people who have lost money in those investments". As a result he will only consider bank guaranteed investments. Bank guaranteed investments are returning 1%. Bradley has a marginal tax rate of 32.5% and pays medicare levy of 2%.

1. Assuming he pays tax at 32.5% plus medicare levy, on the income from his investment, is he preserving the real dollar value of his investment if inflation is 2.5% per annum? Show your workings to justify your answer. (2.5 marks)
2. When considering your calculations, how would you explain the benefits of risk to Bradley? (2.5 marks)

Answer 1

By investing in bank guaranteed investments, Bradley is losing in terms of real dollar value of his investment. Bank is providing returns of 1% and inflation is 2.5%.

Suppose Bradley invests, $ 1000 in bank guaranteed investments.

Returns @ 1% = 1% of $ 1000 = $ 10

Tax = 32.5% of $10 = $ 3.25

Medicare levy = 2% of $10 = $ 0.2

Net returns = 10 - 3.25 - 0.2 = $ 6.55

Inflation @ 2.5% on $ 1000 = $ 25

Real returns = 6.55 - 25 = - $ 18.45

We see that real return is negative.

It is beneficial to invest in investments delivering returns which at least covers the annual inflation rate. In above example, $ 1000 would provide a return of $ 10. $ 1010 will buy lesser amount of goods than $ 1000 today because of inflation. After adjusting for inflation and taxes, the real amount of money left with Bradley will be 1000 - 18.45 = $ 981.55.

So, in order to preserve the value $ 1000 in real sense, Bradley should invest in investments delivering returns more than 2.5%. This means investing in risky investments, but this will be beneficial in preserving real dollar value.