Question: Marla recently inherited 50 000 and is considering two alternatives for
Marla recently inherited $50,000 and is considering two alternatives for investing these funds. Investment A is stock of a C corporation, expected to pay annual dividends of 8 percent. Investment B is stock of an S corporation. Based on income projections, Marla’s share of the S corporation’s ordinary income would be approximately $10,000 per year. However, the S corporation does not expect to make any cash distributions for the foreseeable future. Marla would hold either investment for three years, at which time she believes the C corporation stock could be sold for $60,000 and the S corpora-tion stock could be sold for $90,000. Assume that the initial investment would be made in year 0, dividends on the C corporation stock would be received in years 1, 2, and 3, S corporation earnings would be allocated in years 1, 2, and 3, and either investment would be sold in year 3. Also assume that Marla’s marginal tax rate on ordinary income is 35 percent. Using a 4 percent discount rate, calculate the net present value of after-tax cash flows attributable to either investment and make a recommendation to Marla regarding which investment she should choose.
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