Sisters, Brothers and a Plantation

Sisters

Two sisters, Joan and Jill, askeda merchant bank for advice on investment alternatives. They were looking at either investing in a 12% p.a. debenture or a 10% p.a. preference share. They could, at the time, earn 12% p.a. interest on alternative investments with similar risks. There is no difference between the risk of the preference shares and the debentures, i.e. they have the same credit rating. Both securities have a five year term. The marginal tax rate of both sisters is 40%. The bank’s calculations were as follows:

Preference share

n = 5, PMT = R100 000, i = 12%, FV = R1 000 000

Result: R927 904

Debenture

n = 5, PMT = R120 000, i = 12%, FV = R1 000 000

Result: R 1 000 000

Conclusion: Invest in the debentures.

Joan was impressed with the young man at the bank and followed his advice but Jill was sceptical so invested in the preference shares. At the end of five years they compared notes:

Joan Year / 1 / 2 / 3 / 4 / 5
Opening / 0 / 72 / 149 / 232 / 321
Interest received / 120 / 120 / 120 / 120 / 120
Tax on interest / -48 / -48 / -48 / -48 / -48
Interest opening / 0 / 9 / 18 / 28 / 38
Tax on interest / 0 / -3 / -7 / -11 / -15
Capital returned / 1 000
Closing / 72 / 149 / 232 / 321 / 1 416
Jill Year / 1 / 2 / 3 / 4 / 5
Opening / 0 / 90 / 186 / 290 / 401
Dividend / 100 / 100 / 100 / 100 / 100
Tax on dividend / -10 / -10 / -10 / -10 / -10
Interest opening / 0 / 11 / 22 / 35 / 48
Tax on interest / 0 / -4 / -9 / -14 / -19
Capital returned / 1 000
Closing / 90 / 186 / 290 / 401 / 1 520

Joan could not understand why she was short by R104000 so she contacted CPH and asked him to investigate. He told her that the young man at the bank did not take tax into account in his calculations. She contacted the bank and asked the young manfor an explanation and was told: “We never take tax into account and we are not going to start doing so just because CPH says we should.” Joan asked her lawyers to file for damages.

Brothers

Two brothers, Jack and John, askeda merchant bank for advice on investment alternatives. They were looking at either investing in a five year rental stream of R200000 p.a. costing R700 000 or in a R700 000 12% p.a. five year debenture. They could, at the time, earn 12% p.a. interest on alternative investments with similar risks. There was no difference between the rental stream and the debentures, i.e. they had the same credit rating. Both securities had a five year term. The marginal tax rate of both brothers was 40%. The bank’s calculations were as follows:

Rental stream

n = 5, PMT = R200 000, i = 12% p.a.

Result: R720 000

Debenture

n = 5, PMT = R84 000, i = 12%, FV = R700 000

Result: R 700 000

Conclusion: Invest in the rental stream

Jack was impressed with the young man at the bank and followed his advice but John was sceptical so invested in the debentures. At the end of five years the brothers compared notes:

Jack Year / 1 / 2 / 3 / 4 / 5
Opening / 0 / 72 / 149 / 232 / 321
Rental / 120 / 120 / 120 / 120 / 120
Tax on rental / -48 / -48 / -48 / -48 / -48
Interest opening / 0 / 9 / 18 / 28 / 38
Tax on interest / 0 / -3 / -7 / -11 / -15
Closing / 72 / 149 / 232 / 321 / 416
John Year / 1 / 2 / 3 / 4 / 5
Opening / 0 / 50 / 104 / 162 / 224
Interest received / 84 / 84 / 84 / 84 / 84
Tax on interest / -34 / -34 / -34 / -34 / -34
Interest opening / 0 / 6 / 13 / 19 / 27
Tax on interest / 0 / -2 / -5 / -8 / -11
Capital returned / 700
Closing / 50 / 104 / 162 / 224 / 991

Jack could not understand why he was short by R575000 so he contacted CPH and asked him to investigate. CPH told him that the bank did not take tax into account in their calculations. Jack contacted the bank and asked them for an explanation and was told: “We never take tax into account and we are not going to start doing so just because CPH says we should.” Jack asked his lawyers to file for damages.

Plantation

A plantation expert was asked to value a plantation. He assessed that that R50m would be generated from the sale of timber for a period of 40 years. A discount rate of 20% was agreed on. He calculated the value to be R250m. As this was a pre-tax value, he provided for deferred tax of 29% of R250 = R72,5m leaving an after tax amount of R177,5m.

CPH was asked to check the calculations and he valued the plantation by discounting R50m less tax of 29%, i.e. R35,5m at a discount rate of 20% less tax of 29%, i.e. 14,2% and arrived at R249m. As this was after tax, he grossed the value up to R249/0,71 = R351m and provided for deferred tax of 29% on R351m = R102m.

ONE SHOULD ALWAYS DISCOUNT AFTER TAX CASH FLOW AT AN AFTER TAX RATE!