Question

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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?

What is the 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 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?

What is the deferred compensation?

Answer 1

A - Calculation of Compensation deferred

Step 1 - Calculation of after tax cost of salary

Particulars
Salary	$18800
Tax rate	35%
After tax cost of salary ($18800 - 35%)	$12220

Step 2 - Deferring such salary will save $12220 now and the cost of $12220 after 5 year @9% After tax rate of return is -

Particulars
After tax cost of salary now	$12220
Multiplication (1+r)n Here, r = 9% or 0.09, n = 5 years = (1.09)5 = 1.53862	1.53862
After tax cost of salary after 5 years	$18802

Step 3 - Before tax salary cost which is deferred or deferred compensation

Tax rate = 35%

After tax cost of salary = $18802 = 65%

Deferred compensation = 100%

Particulars	Amount
After tax cost of salary	$18802
Marginal tax rate	35%
Deferred Compensation ($18802/65*100)	$28926

B - Calculation of deferred compensation

Step 1 - Calculation of after tax salary cost if Julie take salary now

= $18800 - 40% = $11280

Step 2 - Calculation of amount after 5 years if Julie invest in taxable bonds

= $11280 * (1.07)5 = $15821 Here, r = 7% or 0.07% & n = 5 years

Step 3 - amount need to be received if tax rate is 40% in order to be indifferent towards salary and deferred compensation

Tax rate = 40%

Amount receivable after 5 years investment = $15821 = 60%

= $15821/60*100 = $26368