Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 20 percent of their salary for five years. For purposes of this problem, ignore payroll taxes in your computations. (Use Table 1.) (Round your intermediate calculations and final answers to the nearest whole dollar amount.)

Problem 13-61 Part a

a. Assume XYZ has a marginal tax rate of 21 percent for the foreseeable future and earns an after-tax rate of return of 13 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 $10,400 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective?

Answer 1

If XYZ is to pay $10,400,

its after tax cost would be [$10,400 × (1 − 0.21)] = 8¸216.00

If it defers the compensation it would save $8,216 after-taxes

After Tax return is 13%

Hence, after- taxes Amount in 5 years =$8,216 × 1.135

                                                                           =$15¸137.45

So, XYZ should be indifferent between paying Joel $8,216 after-taxes now or $15,137.45 after taxes in 5 years.

Assuming XYZ’s marginal tax rate remains at 21%, $15,137.45 after-taxes is $19,161.33 before-taxes [$15,137.45 / (1 − 0.21)].

Hence, amount of deferred compensation = 19,161.33