Question

XYZ Corporation has a deferred compensation plan under which it allows certain employees to defer up to 40 percent of their salary for five years. For purposes of this problem, ignore payroll taxes in your computations. (Use Table 1.) (Round your intermediate calculations and final answers to the nearest whole dollar amount.)

a. Assume XYZ has a marginal tax rate of 21 percent for the foreseeable future and earns an after-tax rate of return of 13 percent on its assets. Joel Johnson, XYZ’s VP of finance, is attempting to determine what amount of deferred compensation XYZ should be willing to pay in five years that would make XYZ indifferent between paying the current salary of $19,600 and paying the deferred compensation. What amount of deferred compensation would accomplish this objective?  

deferred compensation

b. Assume Julie, an XYZ employee, has the option of participating in XYZ’s deferred compensation plan. Julie’s marginal tax rate is 37 percent and she expects the rate to remain constant over the next five years. Julie is trying to decide how much deferred compensation she will need to receive from XYZ in five years to make her indifferent between receiving the current salary of $19,600 and receiving the deferred compensation payment. If Julie takes the salary, she will invest it in a taxable corporate bond paying interest at 10 percent annually (after taxes). What amount of deferred compensation would accomplish this objective?

deferred compensation

Answer 1

A
Current Salary	$19,600
After tax cost 19600*(1-.21)	$15,484
For five years it will be equal to
15484*1.13^5	$28,528.27
XYZ will be indifferent between paying $15,484 after taxes now or $28,528 after 5 years
		Deferred Compensation
Marginal tax rate of XYZ	21%
After taxes	$    28,528
Deferred Compensation= $28528/(1-.21)	$    36,112
B
Current Salary	$19,600
After tax cost 19600*(1-.37)	$12,348
Julie will invest in 10% bonds
Accumulated amount in five years
Investing at 10% for 5 years
12348*1.10^5	$19,886.58
So Julie will be indifferent at point when she receives deferred compensation $19,887 after tax
Deferred Compensation= 19,887/(1-.37)	$31,567