Reference no: EM138236

8-45 Interest equivalent factor Lori Stratton is considering investing in a bond that provides a yield of 8.35 percent or a preferred share with a yield of 7.09 percent. Lori lives in Ontario and at her level of taxable income, the federal tax rate is 29 percent and the provincial tax rate is 15.4 percent.

a.   What should Lori do to compare the yields earned on the two investments?

b.   What yields would Lori use to make the comparison? To answer this question, use the dividend tax credit rates provided in Table.

 (Hennessey 498)

Hennessey, Lawrence J. Gitman and Sean M. Principles of Corporate Finance VitalSource eBook for Athabasca University.Pearson Learning Solutions.VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

 

TABLE : -Taxation of Interest, Dividend, and Capital Gains Income for the 2006 Tax Year

	Interest	Dividend	Capital gains
Income received	$1,000	$ 1,000	$ 1,000
Tax adjustment	0	+450a	-500b
Taxable income	1,000	1,450	500
Federal tax (22%)c	220	319	110
Federal dividend tax credit a	-	275	-
Net federal tax payable	220	44	110
Provincial tax (12.3%)d	123	178.35	61.50
Provincial dividend tax credit a	-	124.00	-
Net provincial tax	123	54.35	61.50
Total taxes payable	343	98.35	171.50
After-tax return	$657	$901.65	$828.50

         ^a For dividends received from taxable Canadian corporations, an individual must first gross-up (increase) the dividend by 45 percent. The taxable income is 1.45 times the actual amount received. But, to compensate for double-taxation issues, a dividend tax credit is allowed that reduces the effective amount of tax on the dividend. The federal dividend tax credit is 27.5 percent of the actual dividend received, while the average provincial dividend tax credit is 12.4 percent of the actual dividend received.

         ^bOnly 50 percent of capital gains are taxable, so 50 percent are excluded from income.

         ^cFor the 2006 tax year, the federal tax rate on taxable income of between $36,378 and $72,756 is 22 percent. Since this tax range is where most middle-income earners are taxed, this rate is used in the example.

         ^dProvincial tax rates for middle-income earners for 2006 vary from a low of 9.15 percent in Ontario and British Columbia to a high of 18.02 percent in Newfoundland. The simple average of the provincial tax rates is 12.3 percent and this rate is used in the example.

This factor means that to be in the same after-tax position, a middle-income investor receiving $1,000 of dividend income must receive $1,372.37 ($1,000 × 1.37237) of interest income. After taxes, both investors would have the same amount, in this case $901.65. The larger amount of interest income is required due to the differences in taxation. An investor receiving $1,372.37 of interest income will pay a combined tax rate of 34.3 percent, or $470.72. This will leave $901.65 after tax. 

Example

The Bank of Nova Scotia example presented an illogical outcome. This was due to tax differences. Therefore, to complete the analysis, the 5.34 percent dividend yield on the Bank of Nova Scotia preferred shares cannot be compared to the 5.55 percent yield on 20-year government debt. These yields are in a different scale. The dividend yield must be adjusted for the differences in taxation by multiplying it by the interest equivalent factor. The interest equivalent yield is 7.33 percent (5.34% × 1.37237). The yield on the preferred share is now 1.78 basis points higher than the yield on the Government of Canada debt (7.33% - 5.55%). The risk-return tradeoff now applies.

 (Hennessey 480-481)

Hennessey, Lawrence J. Gitman and Sean M. Principles of Corporate Finance VitalSource eBook for Athabasca University.Pearson Learning Solutions.VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.

 (Hennessey 480)

Hennessey, Lawrence J. Gitman and Sean M. Principles of Corporate Finance VitalSource eBook for Athabasca University.Pearson Learning Solutions.VitalBook file.

The citation provided is a guideline. Please check each citation for accuracy before use.