Question

Pratt is ready to graduate and leave College Park. His future employer (Ferndale Corp.) offers the following four compensation packages from which Pratt may choose. Pratt will start working for Ferndale on January 1, year 1.

  

Benefit Description	Option 1		Option 2		Option 3			Option 4
Salary	$	60,000	$	50,000	$	45,000		$	45,000
Health insurance	No coverage		$	5,000	$	5,000		$	5,000
Restricted stock		0		0		1,000	shares		0
NQO's		0		0		0			100	options

Assume that the restricted stock is 1,000 shares that trade at $5 per share on the grant date (January 1, year 1) and are expected to be worth $10 per share on the vesting date at the end of year 1 and that no 83(b) election is made. Assume that the NQOs (100 options that each allow the employee to purchase 10 shares at $5 exercise price). The stock trades at $5 per share on the grant date (January 1, year 1) and is expected to be worth $10 per share on the vesting date at the end of year 1 and that the options are exercised and sold at the end of the year. Also assume that Pratt spends on average $3,000 on health-related costs that would be covered by insurance if he has coverage. Assume that Pratt's marginal tax rate is 35 percent. Assume that Pratt spends $3,000 in after-tax dollars for health expenses when he doesn't have health insurance coverage (treat this as an outflow), and that there is no effect when he has health insurance coverage. (Ignore FICA taxes and the time value of money considerations).

Required:

1. What is the after-tax value of each compensation package for year 1?
2. If Pratt’s sole consideration is maximizing after-tax value for year 1, which scheme should he select?

Answer 1

Option 1
Description	Amount ($)	Explanation
(1)Salary	$60,000	Given
(2)Restricted stock	0	Given
(3) Taxable Total	60000	(1)+(2)
(4) Tax rate	35%	Given
(5) Tax paid	21000	(3)*(4)
(6) After tax cash value	39000	(3)-(5)
(7) NQO's	0	Given
(8) Health care expenses	3000	Given
After tax value	36000	(6)+(7)-(8)

Option 2
Description	Amount ($)	Explanation
(1)Salary	$50,000	Given
(2)Restricted stock	0	Given
(3) Taxable Total	50000	(1)+(2)
(4) Tax rate	35%	Given
(5) Tax paid	17500	(3)*(4)
(6) After tax cash value	32500	(3)-(5)
(7) NQO's	0	Given
(8) Health care expenses	0	Given
After tax value	32500	(6)+(7)-(8)

Option 3
Description	Amount ($)	Explanation
(1)Salary	$45,000	Given
(2)Restricted stock	10000	Given
(3) Taxable Total	55000	(1)+(2)
(4) Tax rate	35%	Given
(5) Tax paid	19250	(3)*(4)
(6) After tax cash value	35750	(3)-(5)
(7) NQO's	0
(8) Health care expenses	0	Given
After tax value	35750	(6)+(7)-(8)
Option 4 Description Amount ($) Explanation (1)Salary $45,000 Given (2) NQO's 10000 Given (3) Taxable Total 55000 (1)+(2) (4) Tax rate 35% Given (5) Tax paid 19250 (3)*(4) (6) cash paid at exercise 5000 ($5*1000 shares) (7) After tax cash value 30750 (3)-(5)-(6) (8) Health care expenses 0 Given After tax value 30750 (7)-(8)

Pratt's after-tax value for each
of the options is $36,000, $32,500, $35,750, and
$30,750

Pratt should select option 1 ($36000) because it maximizes his after-tax value.