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Last Time
Time Value of Money
Useful shortcuts
7/7/15
This Time
Time Value of Money
Taxes
Taxes
7/7/15
Tax Rates
Source: Graham, John R., Mark T. Leary, and Michael R. Roberts, 2014, A Century of Corporate
Capital Structure: The Leverage of Corporate America, forthcoming Journal of Financial Economics
Tax Rates
7/7/15
= 354.60
100
100
100
100
+
95.238
+
90.703
+
86.384
+
82.270
Copyright
Michael
R.
Roberts
7/7/15
Taxes Pre-Withdrawal
Post-Withdrawal
Balance
Balance
Interest (35%)
Withdrawal
$354.60
$17.73 -$6.21
$366.12
$100.00
$266.12
$13.31 -$4.66
$274.77
$100.00
$174.77
$8.74 -$3.06
$180.45
$100.00
$80.45
$4.02 -$1.41
$83.06
$83.06
$0.00
7/7/15
Taxes Pre-Withdrawal
Post-Withdrawal
Balance
Balance
Interest (35%)
Withdrawal
$354.60
$17.73 -$6.21
$366.12
$100.00
$266.12
$13.31 -$4.66
$274.77
$100.00
$174.77
$8.74 -$3.06
$180.45
$100.00
$80.45
$4.02 -$1.41
$83.06
$83.06
$0.00
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100
100
100
100
100
(1+ 0.0325 )
100
1+
0.0325
(
)2
100
(1+ 0.0325 )3
100
(1+ 0.0325 )4
7/7/15
= 369.50
100
100
100
100
+
96.852
+
93.804
+
90.851
+
87.991
Copyright
Michael
R.
Roberts
100
100
100
+
96.852
+
93.804
+
90.851
+
87.991
Copyright
Michael
R.
Roberts
7/7/15
7/7/15
Summary
10
7/7/15
Lessons
Taxes reduce our dollar return
The after-tax return, Rt, on an
investment is:
Rt = R (1 t )
where R is the nominal return and t is the
tax rate
Copyright
Michael
R.
Roberts
Coming up next
Time Value of Money
How does inflation affect our returns and
value of money?
11
7/7/15
Problems
Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
Copyright
Michael
R.
Roberts
12
7/7/15
Problem HELOC
You are preparing to buy a car that costs $36,000. You
can pay for the car using an auto loan from the car
manufacturer or using money from your home equity line
of credit (HELOC). The auto loan charges 2.75% interest
per annum. The HELOC charges 3.85% interest per
annum but the interest is tax deductible. If your current
tax rate is 32%, which source of funds should you use?
HELOC after-tax interest rate, Rt = R (1 t ) = 0.0385 (1 0.32 ) = 2.618%
Use the HELOC. The after-tax rate is less than the after-tax
rate on the auto loan. (though this is a no-no in practice)
Copyright
Michael
R.
Roberts
This tax rate reflects the tax rate of the marginal investor,
not the highest statutory tax rate. It also reflects differences
in liquidity and perceived credit quality.
Copyright
Michael
R.
Roberts
13
7/7/15
Problem Retirement 1
How much pre-tax income do you need in retirement
each year in order to meet your retirement needs?
After-tax income = Pre-tax income (1 tax rate ) Pre-tax income =
=
After-tax income
(1 tax rate )
$157,212
= $209,616
(1 0.25 )
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7/7/15
Problem Retirement 2
How much money do you need at the start of your
retirement to meet the pre-tax income demands during
retirement? Assume that you will live on your last year of
income in the first year of retirement and then draw
down your nest egg at the start of the second year
(equivalently, the end of the first year).
Working Years
Age
27
Period
0
Retirement Years
28
29
66
67
68
89
90
39
40
41
62
63
$210k
PV40 =
Copyright
Michael
R.
Roberts
$210k $210k
$209,616
23
1 (1+ 0.05 ) = $2,827,420.9033
0.05
Compare with $2,120,565 ignoring taxes
Problem Retirement 3
How much money do you need today to meet your pretax income demands during retirement if you will live on
your last year of income in the first year of retirement
and then draw down your nest egg at the start of the
second year (equivalently, the end of the first year)?
Working Years
Age
27
Period
0
Retirement Years
28
29
66
67
68
89
90
39
40
41
62
63
$157k
PV0 =
$157k $157k
$2,827, 420.90
$209,616
23
= $401,622.93 PV40 =
1 (1+ 0.05 ) = $2,827,420.9033
40
0.05
(1+ 0.05 )
Compare with $301,217 ignoring taxes
15
7/7/15
Problem Retirement 4
Assuming you do not currently have any savings, how
much do you have to save each year during your
working years to ensure that you will have enough for
your retirement after accounting for the taxes in
retirement? Working Years
Retirement Years
Age
27
Period
0
$301,217
28
29
66
67
68
39
40
41
401,622.93 =
89
90
62
63
C
$401,622.93 0.05
40
1 (1+ 0.05 ) C =
= $23,405.85
0.05
1 (1+ 0.05 )40
Problem Retirement 5
Recognizing the importance of inflation, you realize that
while you will need $157,212 in your first year of
retirement, this need will grow at approximately 2% per
year. Recalculate your annual savings during your
working years to meet this increased after-tax retirement
burden assuming you do not have any savings today?
16
7/7/15
28
1
29
2
Retirement Years
66
39
67
40
68
41
$210k
PV0 =
$3, 400,019.36
= $482,958.07
(1+ 0.05 )40
482,958.07 =
PV40 =
90
63
89
62
Age
Period
$209,616 1+ 0.05
1
23
= $3,400,019.36
C
$482,958.07 0.05
40
1 (1+ 0.05 ) C =
= $28,145.91
0.05
1 (1+ 0.05 )40
Problem Retirement 6
How would your answer to the previous problem change
if your age today was 37, instead of 27, and all other
information remains unchanged. That is, instead of
having 40 years to work and save until retirement, you
only have 30.
17
7/7/15
37
0
38
1
39
2
Retirement Years
66
29
67
30
68
31
After-Tax
$157k
Before Tax = After Tax / (1 Tax Rate)
(1-0.25)
Before-Tax
$210k
PV0 =
$3,400,019.36
= $786,687.80
(1+ 0.05 )30
PV30 =
30 1
90
53
89
52
Age
Period
$209,616 1+ 0.05
1
23
= $3,400,019.36
= $51,175.17
18