It is late 1999 and you are a successful oil executive currently working in Alaska for a major oil company. Tomorrow morning you will have the opportunity to negotiate with your employer to receive some amount of deferred salary in 5 years in exchange for $ 75,000 of your year 2000 compensation. If this compensation is not deferred, it will be paid to you on December 31, 1999, as a year- end bonus. Both you and your employer can earn a before- tax rate of return of 12%. Your employer's combined federal and state income tax rate is 40% and is expected to remain constant throughout the 5- year period. Because Alaska does not have an individual income tax, you will pay only a federal tax of 39.6% on income earned in 1999. However, you are being transferred to New York at the beginning of next year, where you will be groomed for a top- level position in the firm. You expect your combined federal, state, and city income tax rate to be 50% in the year 2000 and to remain at this level throughout the 5- year period.
a. What is the highest deferred- compensation payment your employer would be willing to pay?
b. What is the lowest deferred- compensation payment you would settle for?
c. Can you and your employer get together and write a mutually beneficial deferred-compensation contract? Now suppose you are married to a psychic. As you are making your computations in preparation for tomorrow's meeting, your spouse informs you that she is getting a clear image of you drinking beer at a bar on the Gulf Coast of Florida while reading a copy of Deep Sea Fishing Weekly dated 5 years from today and demanding that the bartender give you the AARP discount for retirees ( which you will not get because you are not old enough).
d. Your spouse interprets this image as indicating that you will snap mentally from the stress 5 years from now ( 2004), quit your job, move to Florida, where you become the captain of a small charter boat, and pay federal income taxes at a 31% rate when your deferred compensation is received in the year 2004. Note: Your spouse has never been wrong before. Under these conditions, what is the lowest deferred- compensation pay-ment you would settle for?
e. Under these new conditions, can you and your employer get together and write a mutually beneficial deferred- compensation contract?