Reference no: EM131731293

Question: An investor in a 40% tax bracket on ordinary income invests in a product that earns a pre-tax return of 10%. Sixty percent of the income is distributed as a capital gain that is taxed at 40% of the ordinary income tax rate. What is the investor's total after-tax return? The investor's total after-tax return is the weighted average of the after-tax returns of the return components. Sixty percent of the total return (i.e., 6%) is taxed at a capital gains rate of 16% (found as 40% × 40%), leaving an after tax capital gain return of 5.04%.

Forty percent of the total return (i.e., 4%) is taxed at the ordinary rate of 40%, leaving an after-tax ordinary income return of 2.40%. The total weighted average is 7.44%, found as the sum of the two components (5.04% + 2.40%). This can also be found as the pre-tax return of 10% reduced by the weighted average tax rate of 25.6%. The average tax rate of 25.6% reflects the weighted average of 60% of the income being taxed as capital gains at 16%, and 40% of the income being taxed at the ordinary rate of 40%.