Question

Roy decides to buy a personal residence and goes to the bank for a $150,000 loan. The bank tells him that he can borrow the funds at 4% if his father will guarantee the debt. Roy's father, Hal, owns a $150,000 CD currently yielding 3.5%. The Federal rate is 3%. Hal agrees to either of the following:

Roy borrows from the bank with Hal's guarantee to the bank.
Cash in the CD (with no penalty), and lend Roy the funds at 2% interest.
Hal is in the 32% marginal tax bracket. Roy, whose only source of income is his salary, is in the 12% marginal tax bracket. The interest Roy pays on the mortgage will be deductible by him.

Considering only the tax consequences, answer the following. If required, round the interim calculation for the tax on interest income to the nearest dollar. Final answers should be rounded to the nearest dollar, if required.

a. The loan guarantee:
Hal's interest income from the CDs would be $ before taxes and $ after taxes.

Roy's interest expense from the bank loan would be $ before taxes and $ after taxes.

This arrangement would produce an overall negative cash flow after taxes to the family of $.

b. The loan from Hal to Roy:
Hal's tax on the imputed interest income from the loan to Roy would be $.

Roy's tax benefit from the imputed interest expense from Hal's loan would be $.

This arrangement would produce an overall negative cash flow after taxes to the family of $.

c. Which option will maximize the family's after-tax wealth?
The loan from Hal to Roy

Answer 1

Answer:

Cash in the CD (with no penalty) and lend Roy the funds at 2% interest.will maximize the family’s after-tax wealth

Explanation:

According to the original question, we have the marginal tax bracket as 33%, rather than 32%

Roy was also given to have a 12% marginal tax bracket.

Do confirm if these are right the values or else, substitute your values into the values used in the calculations and you will still get your right answer.

Working:

1) Roy borrows from the bank with Hal’s guarantee provided to the bank

Interest Revenue to Family = 3.5%*150000 = $ 5250

Tax Expenses = 5250*33% = $ 1732.50

After Tax Interest Revenue = $ 3517.50

After Tax Interest Expenses = 150000*4%*(1-15%) = $ 5100

Change in Family’s after-tax wealth = 3517.50 - 5100

Change in Family’s after-tax wealth = - $ 1582.50

Cash in the CD (with no penalty) and lend Roy the funds at 2% interest.

Interest Revenue to Family = 2%*150000 = $ 3000

Tax Expenses = 3000*33% = $ 990

After Tax Interest Revenue = $ 2010

After Tax Interest Expenses = 150000*2%*(1-15%) = $ 2550

Change in Family’s after-tax wealth = 2010-2550

Change in Family’s after-tax wealth = - $ 540