The Lynch Bull investment company suggests that Steven Comstock, a wealthy New York City investor (his incremental


The Lynch Bull investment company suggests that Steven Comstock, a wealthy New York City investor (his incremental income tax rate is 38.6%), 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% coupon rate (the bonds pay 5% of $100,000, which equals $5000 interest per year). These bonds can be purchased at their present market value of $75,000. At the end of each year, Steve will receive the $5000 interest, and at the end of 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. 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?

When companies need to raise money, issuing bonds is one way to do it. A bond functions as a loan between an investor and a corporation. The investor agrees to give the corporation a specific amount of money for a specific period of time in exchange...
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a...
Face Value
Face value is a financial term used to describe the nominal or dollar value of a security, as stated by its issuer. For stocks, the face value is the original cost of the stock, as listed on the certificate. For bonds, it is the amount paid to the...
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