Assume all investors have a choice between investing in equity that will offer a 10% return in the form of capital gains or investing in debt that will offer a 14% return in the form of interest
Income. Investor A pays taxes at the rate of 35%, and Investor B pays taxes at the rate of 20%
On ordinary income. Both pay taxes at the rate of 15% on capital gain income. Which type of
Investment should each investor make?

Question

Quizplus · Accepted Answer

Investor A: If investing in equity, after-tax return = 10% x (1-0.15) x (1-0.35) = 4.55%
If investing in debt, after-tax return = 14% x (1-0.35) = 9.1%
Therefore, Investor A should invest in debt for an after-tax return of 9.1%.

Investor B: If investing in equity, after-tax return = 10% x (1-0.15) x (1-0.20) = 8.5%
If investing in debt, after-tax return = 14% x (1-0.20) = 11.2%
Therefore, Investor B should invest in debt for an after-tax return of 10.5%.

Hence, both investors should invest in debt as it offers a higher after-tax return for both. Investor A should invest in debt to earn a 9.1% after-tax return [(14%*(1-0.35)) = 9.1%] which is higher than the 8.5% after-tax return [(10%*(1-0.15)*(1-0.35)) = 8.5%] from equity. Investor B should also invest in debt to earn a higher after-tax return of 10.5% [(14%*(1-0.20)) = 11.2%, but capped at 10.5% due to the tax rate ceiling] than the 10% after-tax return [(10%*(1-0.15)) = 8.5%] from equity. Therefore, both investors should invest in debt which offers higher after-tax returns compared to equity.

Assume All Investors Have a Choice Between Investing in Equity