Question

Mr. Lew is entitled to a $5,200 bonus this year (year 0). His employer gives him two options. He can either receive his $5,200 bonus in cash, or the employer will credit him with $4,500 deferred compensation. Under the deferral option, the employer will accrue 6 percent annual interest on the deferred compensation. Consequently, the employer will pay $8,059 ($4,500 plus compounded interest) to Mr. Lew when he retires in year 10. Which option has the greater NPV under each of the following assumptions?

a. Mr. Lew's current marginal tax rate is 28 percent, and his marginal tax rate at retirement will be 15 percent.

b. Mr. RS’s current marginal tax rate is 28 percent, and his marginal tax rate at retirement will be 28 percent.

In making calculations, use a 5 percent discount rate. Please show computation

Answer 1

Solution

a
Particulars	Amount
Deferred Compensation in Year 10	$8,059
Less- tax Rate @ 15 %	$1,208.85
After Tax Compensation	$6,850.15
Net Present Value $6850.15 * 0.614 (0.614 is present value factor of 5% at 10th year)	$4,205.99
Current compensation $5200 - ($5200*28%)	$3,744.00
NPV of deffered compensation	$4,205.99
In order to maximise NPV he should
deferr the compensation
b
Particulars	Amount
Deferred Compensation in Year 10	$8,059
Less- tax Rate @ 28 %	$2,256.52
After Tax Compensation	$5,802.48
Net Present Value $6850.15 * 0.614 (0.614 is present value factor of 5% at 10th year)	$3,562.72
Current compensation $5200 - ($5200*28%)	$3,744.00
NPV of deffered compensation	$3,562.72
In order to maximise NPV he should
accept the current compensation

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