Question

1. Suppose you invest $100,000 in a C corporation for 10 years. You expect the corporation to earn 8% pa before any corporate taxes and any investor level taxes.  The firm does not plan to pay any dividends over the 10 year period. You currently face a 40% tax rate on ordinary income, and 20% tax rate on capital gains.  The corporation faces a tax rate of 35%.  The tax rates are not expected to change.

What is your after-tax dollar accumulation at the end of the 10 year holding period?

What is your annualized after tax rate of return?

2. Instead of investing your $100,000 in the C corporation, you invest it in an S corporation.

What is your after-tax dollar accumulation at the end of the 10 year holding period?

What is your annualized after tax rate of return?

3. Does your answer in 2. differ if the S corporation pays all of its earnings out in dividends?  Please make explicit any assumptions as to what you as the investor does with the dividends (do you spend or do you reinvest).

Answer 1

1. After – tax dollar accumulation at the end of 10 year holding period

After- tax accumulation = 100000 {(1+0.08(1-0.35) ^10(1-0.2) +0.2((100000) = 152815.1

Annualized after tax rate of return

R = {152815.1/100000} ^ (1/10)-1=4.33%

2.Instead of investing your $100000 in the C Corporation, you invest it in an S corporation

After- tax accumulation = 100000 {(1+0.08(1-0.40)} ^10 = 159813.3

Annualized after tax rate of return

R = {159813.3/100000} ^ (1/10)-1=4.80%