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Bernie and Pam Britten are a young married couple beginning careers and establishing a
household. They will each make about $50,000 next year and will have accumulated
about $40,000 to invest. They now rent an apartment but are considering purchasing a
condominium for $100,000. If they do, a down payment of $10,000 will be required.
They have discussed their situation with Lew McCarthy, an investment advisor and
personal friend, and he has recommended the following investments:
•The condominium - expected annual increase in market value = 5%.
•Municipal bonds - expected annual yield = 5%.
•High-yield corporate stocks - expected dividend yield = 8%.
•Savings account in a commercial bank-expected annual yield = 3%.
•High-growth common stocks - expected annual increase in market value = 10%;
expected dividend yield = 0.
1.Calculate the after-tax yields on the foregoing investments, assuming the Brittens have
a 28% marginal tax rate (based on Public Law 108-27, The Jobs and Growth Tax Relief
Reconciliation Act of 2003).
After-tax yields:
1) Condominium, 5%, capital gain on main home is most likely tax-free
2) Municipal bonds, 5%, yield on municipal bond is tax-exempt
3) Dividends are 8% before taxes. These are qualified dividends that will be taxed at
either 5% or 15%. Given the Brittens’ income these would probably be taxed at 5%
for an after tax yield of 7.6%
4) Interest income on a savings account at a commercial bank is 3% before taxes.
Interest is taxed as ordinary income. In the 28% marginal tax bracket, the after-tax
yield is 2.16% = (3% x (1-.28)).
5) High growth common stocks. Tax rates on long-term capital gains will apply.
These will be taxed at either 5% or 15%. If the tax rate is 5%, then the after tax
yield is 9.5%.
2.How would you recommend the Brittens invest their $40,000? Explain your answer.
SHOW ALL WORK AND EXPLAIN EACH STEP CAREFULLY.
Since the High-growth Common Stock offers the highest After-tax yield, then the
couple should invest in high-growth common stock. The couple should be advised,
however that the higher the return, the grater is the risk. If I am the couple’s
investment advisor, I would also factor the standard deviation (a measure of risk)
into the calculations so as to be fully aware of the pros and cons of each investment.
Therefore, in the short run, the condominium may be the best investment because
It provides tax-free capital appreciation and the additional tax advantage of
deductible mortgage interest. Of the other investments listed, high-growth common
stocks appear to be the best long-term alternative.
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