Chapter 3

Question 1

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. When should she pay the $20,000 bill—this year or next?

Answer 1

Option 1: Pay $20,000 bill in December:
$20,000 tax deduction x 37 percent marginal tax rate = $7,400 in present value tax savings.

After-tax cost = Pretax Cost – Present Value Tax Savings
= $20,000 – $7,400 = $12,600

Option 2: Pay $20,000 bill in January:
$20,000 tax deduction x 37 percent marginal tax rate = $7,400 in tax savings in one year.

Present Value of Tax Savings = $7,400 x .893 (Discount Factor, 1 Year, 12 percent) = $6,608

After-tax cost = Pretax Cost – Present Value Tax Savings
= $20,000 – $6,608 = $13,392

Paying the $20,000 in December is the clear winner. Accelerating her payment from January to December will increase the present value of the cash outflow by a few days. Thus, there is a minor present value cost associated with accelerating her payment.

Question 2

Manny, a calendar-year taxpayer, uses the cash method of accounting for his sole proprietorship. In late December he performed $20,000 of legal services for a client. Manny typically requires his clients to pay his bills immediately upon receipt. Assume Manny’s marginal tax rate is 37 percent this year and next year, and that he can earn an after-tax rate of return of 12 percent on his investments. Should Manny send his client the bill in December or January?

Answer 2

Option 1: Send $20,000 bill in December:
$20,000 taxable income x 37 percent marginal tax rate = $7,400 in present value tax

After-tax income = Pretax income – Present Value Tax
= $20,000 – $7,400 = $12,600

Option 2: Send $20,000 bill in January:
$20,000 taxable income x 37 percent marginal tax rate = $7,400 in tax in one year.
Present Value of Tax = $7,400 x .893 (Discount Factor, 1 Year, 12 percent)= $6,608
After-tax income = Pretax income – Present Value Tax
= $20,000 – $6,608 = $13,392

Sending the $20,000 bill in January is the clear winner.  Delaying the invoice to January will decrease the present value of the cash inflow by a few days. Thus, there is a minor present value cost associated with delaying the income.

Question 3

Dennis is currently considering investing in municipal bonds that earn 6 percent interest, or in taxable bonds issued by the Coca-Cola Company that pay 8 percent. If Dennis’ tax rate is 22 percent, which bond should he choose? Which bond should he choose if his tax rate is 32 percent? At what tax rate would he be indifferent between the bonds? What strategy is this decision based upon?

Answer 3

Dennis’ after-tax rate of return on the tax exempt bond is 6 percent (i.e., the same as its pretax rate of return). The Coca-Cola Company bond pays taxable interest of 8 percent. Dennis’ after-tax rate of return on the Coca-Cola Company bond is 6.24 percent (i.e., 8 percent interest income – (8 percent x 22 percent) tax = 6.24 percent). Dennis should invest in the Coca-Cola Company bond.

If Dennis’ marginal tax rate is 32 percent, his after-tax rate of return on the Coca-Cola Company bond would be 5.44 percent (i.e., 8 percent interest income – (8 percent x 32 percent) tax = 5.44 percent). Dennis should invest in the tax exempt bond in this situation.

Dennis would be indifferent between the two bonds if his marginal tax rate is 25 percent.

After-tax return = Pretax return x (1 – marginal tax rate)
6 percent = 8 percent x (1 – marginal tax rate) = 8 percent – (8 percent x marginal tax rate)
8 percent x marginal tax rate = 2 percent

marginal tax rate = 2 percent / 8 percent = 25 percent

This example is an illustration of the conversion planning strategy.