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Investment Stocks

Your best friend consults you for investment advice. You learn that his tax rate is 35%, and he
has the following current investments and debts:
■ A car loan with an outstanding balance of \$5000 and a 4.8% APR (monthly compounding)
■ Credit cards with an outstanding balance of \$10,000 and a 14.9% APR (monthly
compounding)
■ A regular savings account with a \$30,000 balance, paying a 5.50% EAR
■ A money market savings account with a \$100,000 balance, paying a 5.25% APR (daily
compounding)
■ A tax-deductible home equity loan with an outstanding balance of \$25,000 and a 5.0%
APR (monthly compounding)

a. Which savings account pays a higher after-tax interest rate?
b. Should your friend use his savings to pay off any of his outstanding debts? Explain.

Solution Preview

Effective interest rate (EAR) on car loan = (1+4.8%/12)^12-1=4.9070% - No tax deduction benefit
Credit card EAR = (1+14.9%/12)^12-1=15.9609% - no tax deduction benefit
Savings account EAR = 5.5% After tax savings EAR = 5.5%*(1-35%)=3.575%
Money market savings ...

Solution Summary

The solution discusses the investment stocks case study.

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