Question

Sarah wants to invest $2M. Based on her income she is currently in the 28% tax brackets for ordinary income and in the 15% bracket for Long term capital gains. Her tax bracket for state income tax purposes are 5% and 0% on long term capital gains. Requirements: for each of the four situations below, determine NPV of after tax cash flows:

SItuation 1 situation 2 situation 3 situation 4

Type: Corporate bonds municipal bonds corporate stocks municipal bonds

Time horizon: 5 years 7 years 8 years 9 years

Income: 11% interest annually 6.5% interest annually $35,000 dividends 6% interest annualy

Discount rate: 6% 5% 5% 5.5%

Repayment/sale repaid after 5 years repaid after 7 years sold after 8 yrs for $1,850,000 repaid after 9 years

Comments: taxable at ord income rates (non-taxable for fed income tax taxable at long term capital gain rates non-taxable for fed and state income tax

but state income tax of 5% applies)

Answer 1

Situation 1-Corporate Bonds.

Year	Purticulers	cash flow	Discounting factor@6%	Discounted cash flow
(A)	(B)	(C)	(D)	(E=C*D)
1	Initial Invstment	2 Million	1	-2 Million
1-5	Interest income after tax(2 Million*11%) *67%	.1474 Million	4.2124	.6209
5	Terminal value	2 million	.7473	1.4946
	Net Present value(-2+.6209+1.4946)			.1155

Notes,

1.The interest you earn from a corporate bond is subject to both federal income tax and state income tax.(28%+5%)

2. An investor can only receive capital gains from a corporate bond if he sells the bond prior to its maturity.

Situation 2-Municipal Bonds

Year	Purticulers	cash flow	Discounting factor@5%	Discounted cash flow
(A)	(B)	(C)	(D)	(E=C*D)
1	Initial Invstment	2 Million	1	-2 Million
1-7	Interest income after tax(2 Million*6.5%) *95%	.1235Million	5.7863	.7146
7	Terminal value	2 million	.7107	1.4214
	Net Present value(-2+.7146+1.4214)			.136

Notes,

Municipal bonds are commonly tax-free at the federal level, but can be taxable at state under certain circumstances, in present case it is assume that income from these bonds taxable at state level @5%.

Situation 3-Corporate Stocks.

Year	Purticulers	cash flow	Discounting factor@5%	Discounted cash flow
(A)	(B)	(C)	(D)	(E=C*D)
1	Initial Invstment	2 Million	1	-2 Million
1-8	Divident Income	.035 million	6.4632	.2262
8	Terminal value	1.85 million	.6768	1.2521
	Net Present value(-2+.2262+1.2521)			-5217

Situation 4-Municipal Bonds

Year	Purticulers	cash flow	Discounting [email protected]%	Discounted cash flow
(A)	(B)	(C)	(D)	(E=C*D)
1	Initial Invstment	2 Million	1	-2 Million
1-9	Interest income after tax(2 Million*6%) *95%	.114Million	6.9522	.7925
9	Terminal value	2 million	.6176	1.2352
	Net Present value(-2+.7925+1.2352)			.0277

Notes,

Municipal bonds are commonly tax-free at the federal level, but can be taxable at state under certain circumstances, in present case it is assume that income from these bonds taxable at state level @5%.