Question

Melinda invests $200,000 in a City of Heflin bond that pays 6% interest. Alternatively, Melinda could have invested the $200,000 in a bond recently issued by Surething, Inc., that pays 8% interest with similar risk and other non tax characteristics to the City of Heflin bond. Assume Melinda's marginal tax rate is 25%.

A. What is her after-tax rate of return for the City of Heflin bond?

B. How much explicit tax does Melinda pay on the City of Heflin bond?

C. How much implicit tax does she pay on the City of Heflin bond?

D. How much explicit tax would she have paid on the Surething, Inc.,bond?

E. What is her after-tax rate of return on the Surething, Inc., bond?

Answer 1

Concepts and reason

Accounting: Accounting is a process of recording the transactions, classifying them in a specific manner, and then it is the process of summarizing and analyzing to interpret the results. It is a process of preserving the accounts.

Cost: Cost is any value spent to produce a product or to render any service. The types of costs are fixed cost and variable cost.

Fundamentals

Bonds: Bonds are the promise made between two or more persons legally. Bonds are issued by the companies for raising their capital balance. Interest is received during regular intervals by the purchaser.

Tax: A tax may be defined as an involuntary contribution from individuals or corporations as required by law, with the purpose of raising revenue for the functioning of the public and government of a state. The tax contribution by the tax payers are not directly related to the benefits or privileges received from the concerned government.

Return on investment (ROI): Return on investment is the ratio between operating profit and capital employed. It is used in financial planning for measuring the performance of business.

Interest: Interest refers to the amount that is paid by the person who borrows it to the person who lends it due to the principal borrowed. It may be of regular term or for a fixed period with a time interval. The percentage of interest differs accordingly.

Explicit cost: The explicit cost is referred as the cost that can be easily identified by the business. It is a direct payment made to others in the course of running a business such as wage, materials and rent.

Implicit cost: The implicit cost is also termed as imputed cost or notional cost. it is already occurred but necessarily shown or reported as a separate expense.

1)

Determine the after tax-rate of return of “M” for the city “H” Bond.

The pre-tax rate of return of “M” is considered to be the after tax rate of return for the city “H” bond.

2)

Determine the explicit tax paid by “M” on the city of “H” Bond:

The explicit tax is not required to pay by “M” on the city of “H” Bond. ”M” is free from paying the explicit tax.

3)

Determine the implicit tax paid by “M” on the city of “H” Bond.

Therefore, the implicit tax paid by “M” on the city of “H” Bond is $4,000.

4)

Determine the explicit tax paid by “M” on the “S” Inc. Bond.

Therefore, the explicit tax paid by “M” on the “S” Inc. Bond is $4,000.

5)

Determine the after tax-rate of return of “M” on the “S” Inc. Bond:

Therefore, the after tax-rate of return of “M” on the “S” Inc. Bond is 6%.

Working notes:

Determine the interest earned by “M” on the “S” Inc. Bond:

Therefore, the interest earned by “M” on the “S” Inc. Bond is $12,000.

Ans: Part 1

The after tax rate of return of “M for the city “H” Bond is 6%.

Part 2

The explicit tax paid by “M” on the city of “H” Bond $0.

Part 3

The implicit tax paid by “M” on the city of “H” Bond is $4,000.

Part 4

The explicit tax paid by “M” on the “S” Inc. Bond is $4,000.

Part 5

The after tax-rate of return of “M” on the “S” Inc. Bond is 6%.