7/7/15

Time Value of Money:

Taxes
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania

Copyright Michael R. Roberts

Last Time
Time Value of Money
Useful shortcuts

Copyright Michael R. Roberts

7/7/15

This Time
Time Value of Money
Taxes

Copyright Michael R. Roberts

Taxes

Copyright Michael R. Roberts

7/7/15

Tax Rates

Source: Graham, John R., Mark T. Leary, and Michael R. Roberts, 2014, A Century of Corporate
Capital Structure: The Leverage of Corporate America, forthcoming Journal of Financial Economics

Copyright Michael R. Roberts

Tax Rates

How do taxes impact our returns?

Copyright Michael R. Roberts

7/7/15

Example Savings (Discounting)

How much do you have to save today
to withdraw $100 at the end of each
of the next four years if you can earn
5% per annum?

Copyright Michael R. Roberts

Example Savings (Discounting)

Recall
0

= 354.60

100

100

100

100

+ 95.238
+ 90.703
+ 86.384
+ 82.270
Copyright Michael R. Roberts

7/7/15

Example Savings (Account)

Pre-Withdrawal
Post-Withdrawal
Balance
Balance
Year Interest
Withdrawal
0
$354.60
1
$17.73
$372.32
$100.00
$272.32
2
$13.62
$285.94
$100.00
$185.94
3
$9.30
$195.24
$100.00
$95.24
4
$4.76
$100.00
$100.00
$0.00

Copyright Michael R. Roberts

Savings with Taxes (Account)

Year
0
1
2
3
4

Taxes Pre-Withdrawal
Post-Withdrawal
Balance
Balance
Interest (35%)
Withdrawal
$354.60
$17.73 -$6.21
$366.12
$100.00
$266.12
$13.31 -$4.66
$274.77
$100.00
$174.77
$8.74 -$3.06
$180.45
$100.00
$80.45
$4.02 -$1.41
$83.06
$83.06
$0.00

Copyright Michael R. Roberts

7/7/15

Savings with Taxes (Account)

Year
0
1
2
3
4

Taxes Pre-Withdrawal
Post-Withdrawal
Balance
Balance
Interest (35%)
Withdrawal
$354.60
$17.73 -$6.21
$366.12
$100.00
$266.12
$13.31 -$4.66
$274.77
$100.00
$174.77
$8.74 -$3.06
$180.45
$100.00
$80.45
$4.02 -$1.41
$83.06
$83.06
$0.00

We are $100 $83.06 = $16.94 short.

Taxes reduce funds available for
withdrawal. We run out of money early
Copyright Michael R. Roberts

Lesson: Taxes reduce the return on

our investment, R

Copyright Michael R. Roberts

7/7/15

After-tax Discount Rate

Rt = R x (1 t)
For our example:
5% x (1 35%) = 3.25%

Copyright Michael R. Roberts

Savings with Taxes

0

100

100

100

100

100
(1+ 0.0325 )

100
1+
0.0325
(
)2

100

(1+ 0.0325 )3
100

(1+ 0.0325 )4

Copyright Michael R. Roberts

7/7/15

Savings with Taxes

0

= 369.50

100

100

100

100

+ 96.852
+ 93.804
+ 90.851
+ 87.991
Copyright Michael R. Roberts

Savings with Taxes

0

= 369.50 > 354.60 100

100

100

100

+ 96.852
+ 93.804
+ 90.851
+ 87.991
Copyright Michael R. Roberts

7/7/15

Savings with Taxes

PostWithdrawal
Pre-Withdrawal
Balance
Year Interest Taxes
Withdrawal Balance
0
$369.50
1
$18.47 -$6.47
$381.51
$100.00
$281.51
2
$14.08 -$4.93
$290.66
$100.00
$190.66
3
$9.53 -$3.34
$196.85
$100.00
$96.85
4
$4.84 -$1.69
$100.00
$100.00
$0.00

Copyright Michael R. Roberts

Savings with Taxes

PostWithdrawal
Pre-Withdrawal
Balance
Year Interest Taxes
Withdrawal Balance
0
$369.50
1
$18.47 -$6.47
$381.51
$100.00
$281.51
2
$14.08 -$4.93
$290.66
$100.00
$190.66
3
$9.53 -$3.34
$196.85
$100.00
$96.85
4
$4.84 -$1.69
$100.00
$100.00
$0.00

Implication: We need to save more to

($369.50 > $354.60) to withdraw $100
each year after taxes
Copyright Michael R. Roberts

7/7/15

Savings with Taxes

PostWithdrawal
Pre-Withdrawal
Balance
Year Interest Taxes
Withdrawal Balance
0
$369.50
1
$18.47 -$6.47
$381.51
$100.00
$281.51
2
$14.08 -$4.93
$290.66
$100.00
$190.66
3
$9.53 -$3.34
$196.85
$100.00
$96.85
4
$4.84 -$1.69
$100.00
$100.00
$0.00

Note: $369.50 $354.60 = $14.90

which also equals the present value of
the taxes at 5%. (Check this!)
Copyright Michael R. Roberts

Summary

Copyright Michael R. Roberts

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Lessons
Taxes reduce our dollar return
The after-tax return, Rt, on an
investment is:
Rt = R (1 t )
where R is the nominal return and t is the
tax rate
Copyright Michael R. Roberts

Coming up next
Time Value of Money
How does inflation affect our returns and
value of money?

Copyright Michael R. Roberts

11

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Problems

Copyright Michael R. Roberts

Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
Copyright Michael R. Roberts

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Problem HELOC
You are preparing to buy a car that costs $36,000. You
can pay for the car using an auto loan from the car
manufacturer or using money from your home equity line
of credit (HELOC). The auto loan charges 2.75% interest
per annum. The HELOC charges 3.85% interest per
annum but the interest is tax deductible. If your current
tax rate is 32%, which source of funds should you use?
HELOC after-tax interest rate, Rt = R (1 t ) = 0.0385 (1 0.32 ) = 2.618%

Use the HELOC. The after-tax rate is less than the after-tax
rate on the auto loan. (though this is a no-no in practice)
Copyright Michael R. Roberts

Problem Municipal Bonds

The interest on some municipal bonds is tax free, in
contrast to the interest on corporate bonds. If the current
annual interest rates on otherwise similar (i.e., maturity,
credit risk, liquidity) municipal bonds are 1.48% and
1.80%, what is the implied tax rate?
Rt = R (1 t ) t = 1 (Rt / R ) = 1 (1.48 / 1.80) = 17.78%

This tax rate reflects the tax rate of the marginal investor,
not the highest statutory tax rate. It also reflects differences
in liquidity and perceived credit quality.
Copyright Michael R. Roberts

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Problem Retirement (Setup)

You are currently 27 years old and plan on retiring at age
67. Based on current life tables and family history, you
anticipate living another 23 years after retirement
(morbid but important to consider). You estimate that you
will need $157,212 in after-tax income per year in
retirement, during which time all withdrawals from your
retirement savings will be taxed at 25%. Assume that
you can earn 5% per annum on your investments.
Answer the following questions using this information.

Copyright Michael R. Roberts

Problem Retirement 1
How much pre-tax income do you need in retirement
each year in order to meet your retirement needs?
After-tax income = Pre-tax income (1 tax rate ) Pre-tax income =
=

After-tax income
(1 tax rate )

$157,212
= $209,616
(1 0.25 )

Copyright Michael R. Roberts

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Problem Retirement 2
How much money do you need at the start of your
retirement to meet the pre-tax income demands during
retirement? Assume that you will live on your last year of
income in the first year of retirement and then draw
down your nest egg at the start of the second year
(equivalently, the end of the first year).
Working Years
Age 27
Period 0

Retirement Years

28

29

66

67

68

89

90

39

40

41

62

63

$210k

PV40 =
Copyright Michael R. Roberts

$210k $210k

$209,616
23
1 (1+ 0.05 ) = $2,827,420.9033

0.05
Compare with $2,120,565 ignoring taxes

Problem Retirement 3
How much money do you need today to meet your pretax income demands during retirement if you will live on
your last year of income in the first year of retirement
and then draw down your nest egg at the start of the
second year (equivalently, the end of the first year)?
Working Years
Age 27
Period 0

Retirement Years

28

29

66

67

68

89

90

39

40

41

62

63

$157k

PV0 =

$157k $157k

$2,827, 420.90
$209,616
23
= $401,622.93 PV40 =
1 (1+ 0.05 ) = $2,827,420.9033
40
0.05
(1+ 0.05 )
Compare with $301,217 ignoring taxes

Copyright Michael R. Roberts

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Problem Retirement 4
Assuming you do not currently have any savings, how
much do you have to save each year during your
working years to ensure that you will have enough for
your retirement after accounting for the taxes in
retirement? Working Years
Retirement Years
Age 27
Period 0

$301,217

28

29

66

67

68

39

40

41

401,622.93 =

89

90

62

63

C
$401,622.93 0.05
40
1 (1+ 0.05 ) C =
= $23,405.85

0.05
1 (1+ 0.05 )40

Copyright Michael R. Roberts

Compare with $17,554.38 ignoring taxes

Problem Retirement 5
Recognizing the importance of inflation, you realize that
while you will need $157,212 in your first year of
retirement, this need will grow at approximately 2% per
year. Recalculate your annual savings during your
working years to meet this increased after-tax retirement
burden assuming you do not have any savings today?

Copyright Michael R. Roberts

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Problem Retirement 5 (Cont)

Working Years
27
0

28
1

29
2

Retirement Years
66
39

67
40

68
41
$210k

PV0 =

$3, 400,019.36
= $482,958.07
(1+ 0.05 )40
482,958.07 =

PV40 =

90
63

89
62

Age
Period

$210k x 1.0221 $210k x 1.0222

$209,616 1+ 0.05
1

0.05 0.02 1+ 0.02

23

= $3,400,019.36

C
$482,958.07 0.05
40
1 (1+ 0.05 ) C =
= $28,145.91

0.05
1 (1+ 0.05 )40

Compare with $21,109.43 ignoring taxes

Copyright Michael R. Roberts

Problem Retirement 6
How would your answer to the previous problem change
if your age today was 37, instead of 27, and all other
information remains unchanged. That is, instead of
having 40 years to work and save until retirement, you
only have 30.

Copyright Michael R. Roberts

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Problem Retirement 6 (Cont)

Working Years

37
0

38
1

39
2

Retirement Years

66
29

67
30

68
31

After-Tax $157k
Before Tax = After Tax / (1 Tax Rate)
(1-0.25)
Before-Tax $210k

PV0 =

$3,400,019.36
= $786,687.80
(1+ 0.05 )30

CF = $786,687.80 0.05 1 (1+ 0.05 )

PV30 =

30 1

90
53

89
52

Age
Period

$157k x 1.0221 $157k x 1.0222

(1-0.25)
(1-0.25)
$210k x 1.0221 $210k x 1.0222

$209,616 1+ 0.05
1

0.05 0.02 1+ 0.02

23

= $3,400,019.36

= $51,175.17

Compare with $28,145.91 if you start saving at 27

Copyright Michael R. Roberts

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