Question

Required information

Pratt is ready to graduate and leave College Park. His future employer (Ferndale Corp.) offers the following four compensation packages from which Pratt may choose. Pratt will start working for Ferndale on January 1, year 1.

  

Benefit Description	Option 1	Option 2		Option 3			Option 4
Salary	$60,000	$	50,000	$	45,000		$	45,000
Health insurance	No coverage		5,000		5,000			5,000
Restricted stock	0		0		1,000	shares		0
NQOs	0		0		0			100	options

Assume that the restricted stock is 1,000 shares that trade at $5 per share on the grant date (January 1, year 1) and are expected to be worth $10 per share on the vesting date at the end of year 1. Each NQO allows the employee to purchase 10 shares at a $5 strike price). The stock trades at $5 per share on the grant date (January 1, year 1) and is expected to be worth $10 per share on the vesting date at the end of year 1. Also assume that Pratt spends on average $3,000 on health-related costs that would be covered by insurance if he had coverage. Assume that Pratt’s marginal tax rate is 35 percent. Assume that Pratt spends $3,000 in after-tax dollars for health expenses when he doesn’t have health insurance coverage (treat this as an outflow), and that there is no effect when he has health insurance coverage. (Ignore FICA taxes and time value of money considerations). (Leave no answers blank. Enter zero if applicable.)

a. What is the after-tax value of each compensation package for year 1? (tax rates are 35%)

option 1    option 2     option 3    option 4

NQO's

taxable totals

tax rates

tax paid

cash paid at exercise

after-tax value

NQO's

after tax values

b. If Pratt’s sole consideration is maximizing after-tax value for year 1, which scheme should he select?

Option 1

Option 2

Option 3

Option 4

Answer 1

Part A

Description	option 1	option 2	option 3
Salary	60000	50000	45000
Restricted stock	0	0	10000
Taxable income	60000	50000	55000
Tax rate	35%	35%	35%
Tax paid	21000	17500	19250
After tax cash value	39000	32500	35750
NQO's	0	0	0
Health care expense	3000	0	0
After tax value	36000	32500	35750

Description	option 4
Salary	45000
NQO's	10000
Taxable total	55000
Tax rate	35 %
Tax paid	19250
After tax cash value	35750
Health care expense	0
After value	35750

Part B

If Pratt’s sole consideration is maximizing after-tax value for year 1, he should select option 1 because he maximizes his after tax value.