1.Figure 5.4 shows that Wal-Mart’s five-year borrowing rate is 3.1% and GE Capital’s is 10%. Which would you prefer? $500 from Wal-Mart paid today or a promise that the firm will pay you $700 in five years? Which would you choose if GE Capital offered you the same alternatives?
We can use the interest rates each company must pay on a 5-year loan as the discount rate.
2.Your best taxable investment opportunity has an EAR of 4%. You best tax-free investment opportunity has an EAR of 3%. If your tax rate is 30%, which opportunity provides the higher after-tax interest rate?
3.Your uncle Fred just purchased a new boat. He brags to you about the low 7% interest rate (APR, monthly compounding) he obtained from the dealer. The rate is even lower than the rate he could have obtained on his home equity loan (8% APR, monthly compounding). If his tax rate is 25% and the interest on the home equity loan is tax deductible, which loan is truly cheaper?
4.You are enrolling in an MBA program. To pay your tuition, you can either take out a standard student loan (so the interest payments are not tax deductible) with an EAR of 5 1 /2% or you can use a tax-deductible home equity loan with an APR (monthly) of 6%. You anticipate being in a very low tax bracket, so your tax rate will be only 15%. Which loan should you use?
5.Your best friend consults you for investment advice. You learn that his tax rate is 35%, and he has the following current investments and debts:
¦ A car loan with an outstanding balance of $5000 and a 4.8% APR (monthly compounding)
¦ Credit cards with an outstanding balance of $10,000 and a 14.9% APR (monthly compounding)
¦ A regular savings account with a $30,000 balance, paying a 5.50% EAR
¦ A money market savings account with a $100,000 balance, paying a 5.25% APR (daily compounding)
¦ A tax-deductible home equity loan with an outstanding balance of $25,000 and a 5.0% APR (monthly compounding)
a. Which savings account pays a higher after-tax interest rate?
b. Should your friend use his savings to pay off any of his outstanding debts? Explain.