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Inflation and Interest Rates
Overview
Solve three problems addressing inflation and interest rates affecting the financial environment, including the real risk-free rate, expected interest rate, detailed risk premium, and ratio analysis.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
Competency 1: Maximize shareholder wealth.
Compute real risk-free rate of return based on data presented.
Determine yield on 2-year and 3-year Treasury securities.
Competency 2: Evaluate the financial health of the firm
Assess the default risk of a corporate bond.
Context
There are different determinants of market interest rates. Try to answer such questions as, “What determines the shape of the yield curve?” and “How is the yield curve used to estimate future interest rates?,” which are important considerations for financial managers.
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Resources
The following optional resources are provided to support you in completing the assessment or to provide a helpful context.
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.
Assessment Instructions
For this assessment, complete Problems 1–3 on inflation and interest rates affecting financial environment. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:
You may need an HP 10B II business calculator.
You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
If you choose to solve the problems algebraically, be sure to show your computations.
If you use a financial calculator, show your input values.
If you use an Excel spreadsheet, show your input values and formulas.
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Tax Credits on 1040 to Reduce Tax Liability
Assessment 5
Overview
Determine eligibility for available tax credits and complete an official worksheet for each credit, to demonstrate eligibility.Note: Completing a tax form requires specific steps that need to be executed in a sequence. The assessments in this course are presented in sequence and must be completed in order. Incorrect entries in previous assessments will result in incorrect entries in future assessments. Do not complete Assessment 5 until you have submitted and received faculty feedback for Assessment 4.
Tax credits work to lower taxpayer liability rather than provide refund incentives. A tax credit is subtracted directly from the taxpayer’s tax obligation, providing equal relief to all taxpayers. This can make the credit more valuable than a deduction taken during the filing process.
Tax Credits on 1040 to Reduce Tax Liability
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By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
• Competency 1: Analyze the background of the federal income tax system. o Interpret official rules and instructions to record correct entries on tax forms.• Competency 2: Analyze the basics of individual income tax return preparation.o Analyze tax rules to complete tax credit worksheets to prove eligibility.o Apply laws and rules to correctly enter data on Schedule A.o Apply rules and tax tables to record the correct tax owed on the 1040.o Correctly calculate the amount of a refund on the 1040.
Context
“When a new source of taxation is found it never means, in practice, that the old source is abandoned. It merely means that the politicians have two ways of milking the taxpayer where they had one before.” — Henry Louis Mencken, one of the most influential American writers of the early twentieth century.
Politicians have a penchant for finding ways for doing one of two things:
• Enacting tax credits for the benefit of individual taxpayers as a means of putting more money in taxpayer pockets to stimulate the economy.• Enacting tax credit legislation for the benefit of specific groups or industries in the business sector. The hope is that businesses will take the additional monies and reinvest them in the business for the benefit of the economy.
There are credits for foreign taxes paid, child and dependent care expenses, and for the elderly or disabled; credits for education, retirement savings contributions, and residential energy; and child tax credit, adoption, retirement savings, and earned income credits.
Tax Credits on 1040 to Reduce Tax Liability
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To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.
• How do tax credits directly benefit an individual taxpayer?• Which is more advantageous: a deduction or a tax credit?• What can you do if you have already filed your tax return and you discover you are eligible for a tax credit?
Resources
Required Resources
The following resources are required to complete the assessment. Access the following resources by clicking the links provided. Please note that URLs change frequently. Permissions for the following links have been either granted or deemed appropriate
IRS.gov is the homepage for the federal IRS Web site. Use the tabs at the top of the page to navigate the site. The Interactive Tax Assistant and Tax Trails are tools that walk you through a series of questions to find answers to tax questions. Download the appropriate forms and publications from the IRS Web site to complete this assessment.
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FORM 1040: TAX CREDITS
This final section of Form 1040 incorporates a variety of tax credits designed to reduce tax liability for certain taxpayer groups. The unique aspect of these credits is that they are subtracted directly from the total federal tax liability of the taxpayer(s). The affect of these credits can reduce or eliminate the taxpayer’s financial obligation.If a taxpayer is eligible for any/all of the credits, additional tax forms must be completed and filed with the Form 1040.
The primary forms are Form 1116 ( Foreign Tax Credit), Form 2441 (Credit for Child and Dependent Care Expenses), Form 8863 (Education Credits), Form 8880 (Credit for Retirement Savings Contributions, Form 8839 (Qualified Adoption Expenses), and Schedule EIC (Earned Income Credit).Licensed under a Creative Commons Attribution 3.0 License.
Library Resources
• J. K. Lasser Institute. (2015). Your income tax 2015: For preparing your 2014 tax return. Hoboken, NJ: Wiley.
• J. K. Lasser Institute. (2014). Your income tax 2014: For preparing your 2013 tax return. Hoboken, NJ: Wiley.
• Galletta, P. Z. (2014). Taking credit for your work: A roundup of federal tax credits available to individuals. The CPA Journal, 84(12), 17–23.
• Crawford, C., & Crawford, C. (2014). 2014 individual tax landscape. The CPA Journal, 84(12), 6–8.
• Baldwin, D. R., Carlton, L. H., Fava, K. L., Haim, D, Horn, J., Morrow, S., . . . Zidik, D. J., Jr. (2014). Individual taxation: Digest of recent developments: Part II. The Tax Adviser, 45(4), 274–280.
Internet Resources
Access the following resources by clicking the links provided. Please note that URLs change frequently. Permissions for the following links have been either granted or deemed appropriate for educational use at the time of course publication. • lynda.com. (n.d.). Income tax fundamentals: Accounting tutorials. Retrieved from http://www.lynda.com/Business-Accounting-tutorials/Income-Tax-Fundamentals/188210-2.html
o The IRS has a channel on YouTube devoted to income tax information in a video format. There are numerous videos available to help you with the course assessments. Videos are available with closed captions and in ASL and multilingual versions. You can search this channel by topic.
Cruz, A., Deschamps, M., Niswander, F., Prendergast, D., Schisler, D., & Trone, J. (2016). Fundamentals of taxation 2016 [with taxation software] (9th ed.). New York, NY: McGraw-Hill.o Chapter 9, “Tax Credits (Lines 47 through 54 and Line 64A, Form 1040).”
Tax Credits on 1040 to Reduce Tax Liability
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Assessment Instructions
Note: The assessments in this course are presented in sequence and must be completed in order. In Assessments 2–5, you will work step-by-step toward completing a 1040 tax return and all the necessary related forms, based on a provided scenario. Do not complete Assessment 5 until you have submitted and received faculty feedback for Assessment 4. This assessment will require significant research and critical thinking to complete each required form successfully. An incorrect entry on one form will create incorrect entries in other forms.
There are two parts to this assessment. Be sure to complete both parts and submit the necessary materials.• Part 1: Determine eligible tax credits by completing official worksheets.• Part 2: Complete Schedule A and the 1040.
Preparation
• Read the information provided in the scenario below.• Download the following tax forms and instructions from IRS.gov, linked in the Resources under the Required Resources heading:o 1040.o Schedule A.o 2441.o 3800.o 5884.o 6251.o 8826. Part 1Use the information in the scenario, on IRS.gov, and in the interactive IRS tools to interpret official rules and instructions to determine available tax credits.
Tax Credits on 1040 to Reduce Tax Liability
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• Complete an official worksheet for each tax credit to demonstrate eligibility.• Submit each tax credit worksheet. Part 2Use the information in the scenario, on IRS.gov, and in the interactive IRS tools to Interpret official rules and instructions to complete the following:
• Complete Schedule A.• Enter data from Schedule A into the 1040.• Apply the rules and tax tables to calculate the tax owed and the amount of any refund.• Submit Schedule A and the completed 1040. Scenario—Use form for 2016
• Jacob and Taylor Weaver, ages 45 and 42 respectively, are married and are filing jointly in 2016.o They have three children, Ashley, age 9; Patrick, age 6; and John, age 18.o Social Security numbers are: Jacob, 222-33-4444; Taylor, 555-66-7777; Ashley, 888-99-1234; Patrick, 789-56-4321; John, 123-45-6789. Jacob is self-employed as a contractor.o 2016 net income: $133,000.o Clients owe him a total of $53,000 for work completed in 2016.o 2016 estimated tax payments: $25,000.
• Taylor works part-time as a paralegal.o She earned $26,000 in 2016.o Federal income withholding: $2,350.• Weavers $350 paid with their 2015 state tax return.• Jacob and Taylor bought their house in 2016.o Home mortgage interest: $7,246.o Property tax: $2,230.
• Charities: $4,500.• $435 to rent a moving truck.• $8,000 to put new siding on the house.• $11,600 for child care expenses ($5,800 for each child).o It was paid to Lil Tigers Daycare, 1115 S. Garrison St., Muncie, IN 47305 (EIN 98-7654321).• Taylor is a part-time student at Ball State University in Muncie.
o She received a 1098-T indicating tuition and fees for 2016 in the amount of $6,011.• Health insurance for the family, through Taylor’s job, cost $6000 for all 12 months of 2016.o They paid deductibles and co-payments of $550.• Dental insurance for the family was $1200.• Car insurance for the family car was $600.
Tax Credits on 1040 to Reduce Tax Liability
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Default Risk Premium
A Treasury bond maturing in 5 years has a yield of 4 percent. A 5-year corporate bond has a yield of 7 percent. Consider that the liquidity premium on the corporate bond is 0.5 percent. If this is so, what is the default risk on the corporate bond?
A default risk premium is effectively the difference between a debt instrument’s interest rate and the risk-free rate. The premium exists to compensate investors for an entity’s likelihood of defaulting on their debt. It is an additional amount of interest rates paid by a borrower to lender/ investor as a compensation for the higher credit risk of the borrower assuming his failure to pay back the principal amount in future and can be mathematically described as the difference in between the interest rates payable on bond and risk free rate of return.
The premium is determined by Credit history, Liquidity and profitability, Asset ownership
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Expected Interest Rate
For this problem, examine Treasury securities. Considering the following numbers, what would the yield on 3-year Treasury securities be?
Real risk-free = 4%.
Inflation expected at 1.5% for this year and 2% for the next 2 years.
Maturity risk premium = 0.
Treasury Securities
Treasury securities—including Treasury bills, notes, and bonds—are debt obligations issued by the U.S. Department of the Treasury. Treasury securities are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. The income from Treasury securities may be exempt from state and local taxes, but not from federal taxes.
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Required Rate of Return
Stock R’s beta = 1.5
Stock S’s beta = 0.75
Consider that the required return on an average stock is 14 percent. The risk-free rate of return is 6 percent. If this is so, the required return on the riskier stock exceeds the required return on the less risky stock by how much?
The required rate of return (RRR) is the minimum return an investor will accept for owning a company’s stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.
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Evaluating Returns and Cash Flow Streams
Overview
Solve nine problems addressing a range of issues related to valuation of stocks, bonds, annuities, and cash flow streams.
The result of a financial manager’s efforts is ultimately reflected in stock price; maximizing shareowner wealth is what finance is all about. This assessment examines the classic financial tradeoff of risk versus reward.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
Competency 1. Maximize shareholder wealth.
Calculate the required return on a portfolio fund.
Calculate the required rate of return.
Compute the present values of ordinary annuities.
Competency 3. Evaluate capital expenditure investment projects.
Calculate bond evaluation.
Apply computations to explain yield to call.
Calculate yield to maturity using correct calculations.
Compute the after tax cost of debt.
Competency 5. Apply evaluation principles of various financial instruments.
Explain uneven cash flow streams.
Evaluating Returns and Cash Flow Streams
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Context
Stocks
Maximizing shareowner wealth is all about increasing the stock price. Risky investments require higher returns, so when financial managers take greater risks, the logical reaction of shareowners is to demand a higher return. How do they accomplish this? If you were a bondholder, you would require a higher interest payment, but as a shareowner, you get higher returns by lowering the stock price.
So it may appear that a business should be averse to risk because it runs counter to the notion of a higher stock price, but in fact, businesses must take risks to get those higher returns. When relatively risky ventures pay off, or when shareowners believe management can pull it off, the stock price can soar.
Bonds
It is important to examine the main categories of bonds, long-term instruments such as Treasury bonds, corporate bonds, municipal bonds, and foreign bonds. All bonds share certain common features such as face or par value, coupon rate, maturity date, and other provisions. Some bonds are sold at a deep discount and do not provide any coupon interest payments; these are called zero-coupon bonds.
Previously we have talked about the fact that the value of any financial asset should be based on the present value of its future cash flows. This holds true for the valuation of bonds as well. There are different numerical tools used in assessing and comparing different bonds such as yield-to-maturity, current yield, and yield-to-call for callable bonds.
Our analysis of bonds would certainly be incomplete if we did not consider the risks involved in purchasing different types of bonds. Interest rate, reinvestment rate, and default risks are all associated with the investment in bonds. One important observation regarding the bond markets is that they rely on several independent bond rating agencies providing continuous monitoring of the most important bond issuers.
Evaluating Returns and Cash Flow Streams
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Cash Flow
An asset’s value depends on the valuation of the after-tax cash flows this asset is expected to produce.
Questions to consider
To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.
Analyze some of the most important elements of the current tax laws, such as the differences between the treatment of dividends and interest paid and interest and dividend income received. How can financial managers increase shareholder value through managing tax obligations?
Examine the company you work for (if your company is not publicly held, pick a company you are familiar with), and consider the following.
Would you consider this company to be relatively risky? Does the stock rise and fall faster than the market?
What things contribute to the riskiness or stability of the stock?
What is the CAPM and security market line, and how can they be used in assessing share price?
The time value of money is defined as the math of finance for which interest is earned over time by saving or investing money. Why does time value affect almost any financial decision? Under what situations might time value matter less?
Examine the importance of bond ratings and some of the criteria used to rate bonds. Differentiate between interest rate risk, reinvestment rate risk, and default risk. How would a financial manager use bond ratings to increase the value of the firm?
Examine what is meant by the statement that a preferred stock is a hybrid between a common stock and a bond. What factors determine the value of a share of preferred stock?
Identify some of the factors that would cause you to rely more on either NPV or IRR. Does MIRR solve all of IRR’s shortcomings?
Evaluating Returns and Cash Flow Streams
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Resources
The following optional resources are provided to support you in completing the assessment or to provide a helpful context. For additional resources, refer to the Research Resources and Supplemental Resources in the left navigation menu of your courseroom.
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.
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Assessment instructions
For this assessment, complete Problems 1–9 to apply the necessary knowledge to assess returns and cash flow streams. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:
You may need an HP 10B II business calculator.
You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
If you choose to solve the problems algebraically, be sure to show your computations.
If you use a financial calculator, show your input values.
If you use an Excel spreadsheet, show your input values and formulas.
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Returns Estimating and Refinancing Decisions
Part 1 – Estimating Returns
In the given scenario where the company estimates three possible economic outcomes: poor, average, and above-average. In each case, the company speculates a probability of occurrence of 20%, 40%, and 40% respectively. Further, the company also forecasts the possible returns for each possible economic outcome at 10% for a poor economy, 18% for an average economy, and 30% for an above-average economy.
Calculation of expected returns
Given these scenarios, we can estimate the expected returns for the company. The expected returns are calculated for each expected economic forecast and then summed to give the expected returns for the company. This data is tabulated below.
Expected return
Scenario
Probability
Possible returns
ER
Poor economy
20%
10%
2.0%
Average economy
40%
18%
7.2%
Above-average economy
40%
30%
12.0%
Expected return:
21.2%
Returns Estimating and Refinancing Decisions
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Calculation of standard deviation
In addition to the expected return, we can also calculate the standard deviation. In a similar fashion to the expected return calculations, the calculation of the standard deviation involves calculation for each economic forecast and a square root of the summation of the same to indicate the forecast for the company. These calculations are tabulated below.
Standard deviation
Scenario
Probability
Possible returns
SD
Poor economy
20%
10%
0.25%
Average economy
40%
18%
0.04%
Above-average economy
40%
30%
0.31%
0.60%
Standard deviation:
7.76%
How the standard deviation helps better understand what to expect in terms of a return
The standard deviation is useful in the understanding of a return, and in particular the volatility of the return. The standard deviation of the return is a measure of how much the actual return deviates from the expected return. A high standard deviation value implies an increase in the volatility of the company (Gibson, Michayluk, & Van de Venter, 2013). This high level of volatility suggests a higher risk level for the firm.
Returns Estimating and Refinancing Decisions
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Part 2 – Deciding on refinancing
The scenario that requires a decision on whether to refinance the current loan facility is outlined below.
Current loan details:
Principal (Mortgage value)
$100,000
Interest
7%
Years left
14
Negotiated (years ago)
2
Closing costs
$2,000
Amount to be repaid:
$98,000
$200,000
Upon refinancing, the new terms change to those in the table below.
Refinancing:
Interest
5.50%
Years left
15
Closing costs
$1,500
Amount to be repaid:
$82,500
$184,000
Returns Estimating and Refinancing Decisions
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The decision and reasons to refinance
Given the two scenarios above, I would decide the refinance the loan facility. The main reasons behind this decision would be the fact that the amount to be repaid reduces with the refinancing. In addition, the period remaining to pay back the loan facility increases with the decrease in the interest rate payable per year.
Qualitative considerations to consider in the decision to refinance or not refinance
Prior to considering a decision on whether or not to refinance a loan facility, several qualitative considerations are made. These considerations include whether the amount payable decreases or not. A second consideration is whether the payback period for the loan changes upwards or downwards. A third consideration is whether the interest rate reduces or increases with the refinancing. A fourth consideration is whether there is a change in the closing costs associated with the loan facility (Parameswaran, 2011).
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Calculations to help you make the decision to refinance or not to refinance
The sample calculations tabulated above help guide the decision on whether to refinance or not to refinance. In the current loan terms, the amount to be repaid is $98,000. This is calculated using the formula below.
Amount payable =Principal * Interest rate * Number of years
The total amount payable is the sum of the amount payable ($98,000), the closing costs, and the principal amount. The sum of these figures comes to $200,000.
The refinancing scenario terms alter these terms by increasing the number of years, reducing the interest rate, and decreasing the closing costs. As such, the refinancing satisfies three of the qualitative considerations. In order to test for the fourth qualitative consideration, we apply the same formula to the loan facility using the new terms of the refinancing (Brigham & Houston, 2016). In this case, the amount payable comes to $82,500 and the total amount payable is $184,000.
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Therefore, given the reduction in the total amount payable from $200,000 to $184,000, as well as the satisfaction of the qualitative consideration for a refinancing, a refinancing is a better option in this case compared to not refinancing.
Gibson, R., Michayluk, D., & Van de Venter, G. (2013). Financial risk tolerance: An analysis of unexplored factors. Financial Services Review, 22(1), 23–50.
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Bond Valuation
You have two bonds in your portfolio. Each bond has a face value of $1000 and pays an 8 percent annual coupon. Bond X matures in 1 year, and Bond Y matures in 15 years.
If the going interest rate is 4 percent, 9 percent, and 14 percent, what will the value of each bond be? Assume Bond X only has one more interest payment to be made at maturity. Assume there are 15 more payments to be made on Bond Y.
The longer-term bond’s price varies more than the shorter-term bond‘s price when interest rates change. Explain why.
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After-Tax Cost of Debt
The XYZ Inc.’s currently outstanding bonds have a 10 percent yield to maturity and an 8 percent coupon. It can issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40 percent, what is XYZ’s after-tax cost of debt?
What Is the Cost of Debt?
The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.
Impact of Taxes on Cost of Debt
Since interest paid on debts is often treated favorably by tax codes, the tax deductions due to outstanding debts can lower the effective cost of debt paid by a borrower. The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. The company’s marginal tax rate is not used; rather, the company’s state and federal tax rates are added together to ascertain its effective tax rate.
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