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After-tax rate of return on the highest yielding security

3-5
The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T Bonds, which yield 7.5%, state of Florida muni bonds, which yield 5%, and AT & T preferred stock , with a dividend yield of 6%. Shrieves' corporate tax is rate is 35%, and 70% of the dividends received are tax exempt.

Assuming that the investments are equally risky and that Shrieves chooses strictly on the basis of after-tax returns, which security should be selected? What is the after-tax rate of return on the highest yielding security?

3-7

The Menendez Corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be 1.5 Million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Mendndez's federal-plus-state tax rate is 40%

a: set up an income statement. What is Menendez's expected net cash flow?
b: Suppose congress changed the tax laws so that Menendez's depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?
c: Now suppose that Congress instead of doubling Menendez's depreciation, reduced it by 50%. How would profit and net cash flow be affected?
d: If this were your company would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?

Solution Preview

INVESTMENT RATE OF RETURN POST TAX RETURN

Bonds 7.50% 4.88%

Municipal Bonds 5% 5%

Preferred Stock 6% 5.37%

The preferred stock should be selected as its return is 5.37% (which is highest)
a: set up an income statement. What is Menendez's expected net cash flow?
in $mn
Sales 12000000
Less costs 9000000
Profit before depreciation 3000000
Less ...

Solution Summary

This provides the steps to calculate the after-tax rate of return on the highest yielding security

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