Five years ago, Kate purchased a dividend-paying stock for $26,000. For all five

Question

Five years ago, Kate purchased a dividend-paying stock for $26,000. For all five years, the stock paid an annual dividend of 5 percent before tax and Kate’s marginal tax rate was 24 percent. Every year Kate reinvested her after-tax dividends in the same stock. For the first two years of her investment, the dividends qualified for the 15 percent capital gains rate; however, for the last three years the 15 percent dividend rate was repealed and dividends were taxed at ordinary rates. (Do not round intermediate calculations. Round your answers to the nearest whole dollar amount.) b. What will Kate’s investment be worth three years from now (at the beginning of year 9) assuming her marginal tax rate increases to 35 percent for the next three years?

Explanation / Answer

Answer:

Five years ago value of dividend paying stock = $26,000

First two years: dividends qualified for the 15 percent capital gains rate

Dividends as % net of Tax = 5% * (1 - 15%) = 4.25%

Hence amount after first two years = $26,000 * (1 + 4.25%) 2

In last three years tax rate = 24%; hence dividend net of Tax = 5% * (1 - 24%) = 3.8%

Hence amount now (after 5 years of investment) = $26,000 * (1 + 4.25%) 2 *( 1 + 3.8) 3 = $31,602

Answer b:

Next 3 years marginal tax = 35%

Dividend as % net of tax = 5% * (1 - 35%) = 3.25%

Kate’s investment be worth three years from now = $31,602 * (1 + 3.25%) 3

= $34,784

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