Jason and Kerri Consalvo, both in their 50\'s, have $43 comma 000 to invest and

Question

Jason and Kerri Consalvo, both in their 50's, have $43 comma 000 to invest and plan to retire in 10 years. They are considering two investments. The first is a utility company common stock that costs $43 per share and pays dividends of $1.29 per share per year (a 3 % dividend yield). Note that these dividends will be taxed at the same rates that apply to long-term capital gains. The Consalvos do not expect the value of this stock to increase. The other investment under consideration is a highly rated corporate bond that currently sells for $ 1 comma 000 and pays annual interest at a rate of 4.0 %, or $40.00 per $ 1 comma 000 invested. After 10 years, these bonds will be repaid at par, or $ 1 comma 000 per $ 1 comma 000 invested. Assume that the Consalvos keep the income from their investments but do not reinvest it (they keep the cash in a non-interest-bearing bank account). They will, however, need to pay income taxes on their investment income. If they buy the stock, they will sell it after 10 years. If they buy the bonds, in 10 years they will get back the amount they invested. The Consalvos are in the 35 % tax bracket. a. How many shares of the stock can the Consalvos buy? b. How much will they receive after taxes each year in dividend income if they buy the stock? c. What is the total amount they would have from their original $43 comma 000 if they purchased the stock and all went as planned? d. How much will they receive after taxes each year in interest if they purchase the bonds? e. What is the total amount they would have from their original $43 comma 000 if they purchased the bonds and all went as planned? f. Based only on your calculations and ignoring other risk factors, should they buy the stock or the bonds?

Explanation / Answer

a. They have 43,000 to invest

Price of the stock is $43.

So number of shares of the stock that Consalvos can buy = 43,000/43 = 1,000 shares

b. The dividend per share that they receive is $1.29 per year

So, the tax rate is 35%. So after tax dividend income = 1.29*(1-0.35) = $0.8385/share

They have a 1,000 share. So total after tax dividend income = 0.8385*1000 = $838.50

c. Total money that he will have in stock investments = $838.50*10 = $8,385 in 10 years. This is all in the form of dividends. Since the price is not expected to appreciate, he will sell the shares at the same price and there is no capital gain.

d. They receive $40 per thousand invested. So they receive in an year, 40*43 =1,720 a year. Since the tax rate is 35%, after tax income they receive from bonds = 1720*(1-0.35) = 1,118 per year.

e. Total amount they would have = 1,118*10 = 11,180 in 10 years.

f. They should invest in bonds as they get a higher after tax income in bonds than in stocks.

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