Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 40 percent of their salary for five years. (for purposes of this problem, ignore payroll taxes in your computation) (Round your intermediate calculations and final answers to the nearest whole dollar amount.) a. Assume XYZ has a marginal tax rate of 35 percent for the foreseeable future and earns an after-tax rate of return of 12 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 $13,200 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective? Deferred compensation b. Assume Julie, an XYZ employee, has the option of participating in XYZ's deferred compensation plan. Julie's marginal tax rate is 40 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $13,200 and receiving the deferred compensation payment. If Julie takes the salary, she wil invest it in a taxable corporate bond paying interest at 7 percent annually (after taxes). What amount of deferred compensation would accomplish this objective? Deferred compensation

Answer 1

a. If XYZ were to pay $13,200, its after tax cost would be $8,580 ($13,200 * (1-0.35)). If it defers the compensation it would save $8,580 after-taxes. This is equivalent to $15,120.89 after-taxes in 5 years ($8,580 * (1.12)⁵). So, XYZ should be indifferent between paying $8,580 after-taxes now or $15,120.89 after taxes in 5 years. Assuming XYZ’s marginal tax rate remains at 35%, $15,120.89 after-taxes is $23,262.91 before-taxes [$15,120.89/(1-0.35)]

b. If Julie were to take the salary now she would receive $7,920 after tax (13,200 * (1 -0.40)). She would then invest this amount in taxable corporate bonds. The bonds generate 7% annual interest which is taxable. After five years Julie would have accumulated $11,108.21 after taxes by taking the salary and investing it herself [7,920 * (1.07)⁵]. Thus, in order to be indifferent after five years between the salary and deferred compensation, she must receive enough deferred compensation that provides her with $11,108.21 after she pays tax at her 40% marginal tax rate. If she receives $18,513.68, she will have $11,108.21 after taxes [$18,813.68 * (1-0.40)].