Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartAssignment AHanded Out: in course readerDue in Class: Thursday, November 11Financial Planning: Choosing Among Alternative StrategiesThis exercise introduces you to the effects of taxation on the attractive-ness of various investment strategies.Assume the following situation. Yesterday was your 50thbirthday.Today you quit your job to stake your business acumen and personal wealthof $1 million in a new, incorporated business venture. You are the soleshareholder and CEO of this business. Your objective is to develop a planto achieve the highest after-tax net worth on your 65thbirthday.You will retire just after you receive your salary (and final pensioncontribution, if any; see part D below) on your 65thbirthday. On retirement,you will sell your shares in the business for the full value of the underlyingassets. At that time, you will owe capital gains tax at the rate of 30 percenton the difference between the selling price of the shares and your initialinvestment of $1 million. Assume the corporation pays no dividends overthe course of the next fifteen years. Also assume you are unable to makefurther contributions to the capital of the corporation beyond your initial $1million investment.One of your first decisions as CEO is to determine your salary. Tosimplify the analysis, you receive your salary annually on your birthday,beginning with your 51stbirthday. You need to pay yourself enough salaryto cover your personal living expenses after paying personal income tax.Youpersonal living expenses are $40,000 on your 51stbirthday. Yourliving expenses rise at the rate of inflation. Inflation is 4 percent per year.The remainder of your salary (after living expenses and taxes) is availablefor investment. You pay income taxes of 35 percent of your taxable incomeeach birthday.Note that salary you receive is a deduction from corporate income forpurposes of calculating corporate income tax. Income tax rules limit theamount of compensation the corporation may deduct in arriving at taxableincome. In this instance, you feel that the IRS will disallow a deduction forsalary in excess of $100,000 on your 51stbirthday. Assume that the ceilingcSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Assignment Aon compensation payments imposed by the IRS rises at the rate of inflation.On each birthday, you may pay yourself any amount sufficient to cover yourliving expenses after tax and less than the ceiling.Investment AlternativesBusiness Venture: The return on funds invested in your businessventure before your compensation and taxes is 20 percent per year.The corporation’s fiscal year end is your birthday. The corporationpays tax on its taxable income every year at the rate of 40 percent.Taxable Bonds: The annual pretax yield is 10 percent.Municipal Bonds: The annual yield on these tax exempt bonds is7percent.Single Premium Deferred Annuity Contract (SPDA): Deposits intothese contracts are not tax-deductible. Income earned on thecontract accumulates tax-free. The accumulated interest is taxedat ordinary rates in the year of withdrawal. Partial withdrawals aretreated as interest first. No load fees, surrender charges, or excisetaxes are assessed on these contracts. Funds invested in SPDAsearn the same pretax return as taxable bonds.AssignmentWarm-up: The after-tax return over 15 years on the initial $1,000,000invested in the corporation has the same form as the return on SavingsVehicle II in Table 3.1 of the text, (1 + R)15(1 − t)+t, where t is interpretedas the capital gains tax rate and R is the annual after corporate tax returnon the business venture. What is the after-tax return on a dollar of earningsleft in the corporation until the shares are sold when retirement (at age 65)is n years away? Do not proceed to part A until you are sure of your answerto this warm-up question.For parts A, B, and D below, generate a spreadsheet that shows howyou will pay salary, spend, and invest your wealth over the next fifteen yearsto maximize your after-tax net worth on your 65thbirthday. Your analysisshould include a brief description and justification of the strategy you willfollow.Part A: Use the facts above.Page 2Assignment A ACCTG 550Part B : Suppose the personal rate of income tax is 32 percent rather than35 percent. All other facts are as in part A. Explain briefly how and whythe optimal strategy in part B differs from the strategy in part A.Part C : Assume dividends are taxed as income to the recipient. Would itbe better for your corporation to pay you a dividend rather than salary?Would it be better to capitalize the company with debt rather than equity?(A qualitative answer will suffice. No spreadsheet is necessary to answer thequestions in this part.)Part D: Suppose you can direct your corporation to institute a qualifieddefined contribution pension plan in your name. Assume that the amountpaid into the plan can vary from year to year provided the corporation’sannual pension contribution does not exceed the lesser of (i) 25 percent ofyour salary for the year, and (ii) $30,000. The pension plan invests in fullytaxable bonds. All other facts are as in part A.Part E :Ifitwere possible to organize the business venture as a soleproprietorship (or as an S corporation), would it be worthwhile to do so?Why or why not? (A qualitative answer will suffice. No spreadsheet isnecessary to answer the questions in this part.)Page