Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 35 percent of their salary for five years. (For purposes of this problem, ignore payroll taxes in your computations.) PV Table (Round your PV factors to 5 decimal places. Round your intermediate calculations and final answers to the nearest whole dollar amount.)

a. Assume XYZ has a marginal tax rate of 35 percent for the foreseeable future and earns an after-tax rate of return of 9 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 $18,800 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 40 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 $18,800 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 7 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

Answer 1

a. In order to achieve the objective of indifference between the two alternatives, XYZ Corporation would make the following calculations:

XYZ Corporation is indifferent when it pays either $6,580 (35% of salary eligible for retention) today or it pays $10,120 after 5 years. If XYZ Corporation has to pay more than $10,120 to Joel Johnson after 5 years, it would be at a loss since the earnings of XYZ @ 9% from the amount saved on retention of salary would not be sufficient to fully cover such higher amount.

b. In order to compute the amount of deferred compensation, Julie would make the following calculations:

In order to forego amount of $6,580 in the current year, Julie requires deferred salary of $9,230 after 5 years. Any amount less than $9,230 would put Julie at a loss since she can earn more by investing that amount in corporate bonds that yield 7% after tax returns.

Note: The above solutions can alternatively be solved by ignoring the taxation impact in the current and future years since the tax rate remains the same throughout.