Reference no: EM132168112

Question: The Lynch Bull investment company suggests that Steven Comstock, a wealthy New York City investor (his incremental income tax rate is 35%), consider the following investment. Buy corporate bonds on the New York Stock Exchange with a face value (par value) of $100,000 and a 5% interest rate paid annually. These bonds can be purchased at their present market value of $75,000. Each year Steve will receive the $5000 interest, and after 5 years, when the bonds mature, he will receive $100,000 plus the last $5000 of interest. Steve will pay for the bonds by borrowing $50,000 at 10% interest for 5 years. The $5000 interest paid on the loan each year will equal the $5000 of interest income from the bonds. As a result Steve will have no net taxable income during the five years due to this bond purchase and borrowing money scheme. At the end of 5 years, Steve will receive $100,000 plus $5000 interest from the bonds and will repay the $50,000 loan and pay the last $5000 interest. The net result is that he will have a $25,000 capital gain; that is, he will receive $100,000 from a $75,000 investment. (Note: This situation represents an actual recommendation of a brokerage firm.)

(a) Compute Steve's after-tax rate of return on this dual bond-plus-loan investment package.

(b) What would be Steve's after-tax rate of return if he purchased the bonds for $75,000 cash and did not borrow the $50,000? Historical Depreciation.