Question
Melissa Tang recently received an inheritance of $2 million and is now trying to decide how best to invest the funds. Following a preliminary conversation with an investment advisor, she has decided that it would probably be best to split her investments between debt and equity. However, after reading the material that the investment advisor had given her, she was confused about the tax implications of the two types of investments and has asked you to help her determine the taxes she might expect to pay on the various investments that the investment advisor has recommended.
As a first step, you have determined that her marginal federal tax rate is 29% and her marginal provincial tax rate is 16%. You have also determined that the gross up on eligible dividends is 38%, the dividend tax credit is 15.02% of the grossed-up amount, and the provincial tax rate on eligible dividends is 10.5% of the actual dividend.
One of the equity investments that the advisor has recommended is the shares of Anderson Company, which are currently selling for $12.50. Anderson has consistently declared and paid a dividend of $0.75 per share for the past ten years and the advisor has stated that they believe the dividends should remain unchanged for the foreseeable future. The advisor has also stated that they believe that the shares will be trading at a price of $15 in one year's time.
The bond investment that the advisor has recommended is the bonds of Gardner Company. The bonds are currently priced $88 for each $100 face value bond, carry a coupon rate of 6% payable semi-annually, and have 10 years remaining until maturity. Based on anticipated changes in interest rates, the advisor believes that the bonds will be selling for $95 in one year's time.
a. If the investment advisor's beliefs are realized, what is the total tax that Melissa would have to pay if she invests $1,000 in the shares of Anderson Company today and then sells them in one year's time?
b. If the investment advisor's beliefs are realized, what is the total tax that Melissa would have to pay if she purchases 10 $100 face value bonds of Gardner Company today and then sells them in one year's time?
c. If Melissa decides to invest $500,000 in the bonds of Gardner Company and $1.5 million in the shares of Anderson Company, what is the expected after-tax rate of return on her investment portfolio?