Question

Margaret owns land that appreciates at the rate of 10% each year. Ralph owns a zero coupon (i.e., all of the interest is paid at maturity but is taxed annually) corporate bond with a yield to maturity of 10%. At the end of 10 years, the bond will mature and the land will be sold. At the end of the 10 years :

1) Margaret and Ralph will have accumulated the same after-tax amounts.
2) Ralph will have accumulated a greater after-tax amount because the interest on the bond is tax-exempt.
3) Margaret will have accumulated the greater after-tax amount because the gain on the land is tax-exempt.
4) Margaret will have accumulated the greater after-tax amount but only if her marginal tax rate never exceeds 27%.
5) Margaret will accumulate the greater after-tax amount because she earns a return on the deferred taxes.

Answer 1

Margaret will likely accumulate a greater after-tax amount than Ralph because she benefits from a return on the deferred taxes on her land's appreciation, while Ralph's bond interest is taxed annually even though it's not received until maturity.

Step-by-step explanation:

The scenario involves Margaret, who owns land that appreciates annually, and Ralph, who owns a zero-coupon corporate bond with a yield to maturity of 10%. The land and the bond will reach their financial conclusion in 10 years. To analyze who will have accumulated the greater after-tax amount, we must consider the taxation of capital gains on the land versus interest income from the bond. Zero-coupon bonds are taxed annually on the interest that accrues, even though it is not paid out until maturity. In contrast, capital gains on land are only taxed at the time of sale and if the land is held for more than one year, the gains are taxed at the more favorable long-term capital gains rate rather than ordinary income tax rates.

Since neither the appreciation of land nor the interest from the bond is tax-exempt, option 2 and option 3 can be eliminated. For option 4, if Margaret's marginal tax rate exceeds the rate for capital gains, it could affect the comparison negatively. However, it is most accurate that Margaret will accumulate a greater after-tax amount because she earns a return on the deferred taxes (option 5), which allows her to benefit from the compounding effect of the money that would have otherwise been paid in taxes annually were it earned as interest income like Ralph's bond.