Question

Subject Tax Accounting

Maurice is currently considering investing in a high dividend yield stock with no growth potential that pays a 6% dividend yield or bonds issued by The Coca Cola company that pay 8%.If Maurice's ordinary tax rate is 25% and his dividend tax rate is 15%, which investment should he choose? Which investment should he choose if his ordinary tax rate is 30%. At what ordinary tax rate wouls he be indifferent to the stock or to the bond? What strategy is this decision based upon?

Answer 1

1..Assuming same amount of money invested in both stock or bond

After-tax return on stock=6%*(1-15%)=

5.10%

After-tax return on Coca Cola Bonds=8%*(1-25%)=

6.00%

He should choose the Coca Cola bond for it returns the greater after-tax return

2.If his ordinary tax rate is 30%

After-tax return on stock=6%*(1-15%)=

5.10%

After-tax return on Coca Cola Bonds=8%*(1-30%)=

5.60%

He should still choose the Coca Cola bond for it returns the greater after-tax return

3..Ordinary tax rate at which he will be be indifferent to the stock or to the bond

is the tax rate at which the after-tax income will be the same.

so, equating both the after-tax rates,

6%(1-15%)=8%*(1-x%)

solving the above ,

the indifferent ordinary tax rate =x= 36.25%

Indifference strategy -ie. When his ordinary tax rate is 36.25%, he will be indifferent between investing in this stock or Coca Cola bonds, as his after-tax income will be the same under both.

In any case, it needs to be remebered that stock-dividends are more volatile compared to bond- interests as the latter is assured & constant over the life of the bond, whereas stock prices keep changing & dividend amounts are not that certain.