CT1 September 2005 exam Q10 i)

[Polina Hadjipanayiotou]

Hello there, I am a bit confused why in part i of the question attached below the present value of the coupons is not multiplied by the factor (1-0.25) since the question states that "The investor pays tax at 25% on the coupons only", this does mean he pays income tax?
Solution also attached

Thanks in advance,
Polina

 

[Bidza]

The trick lies with the redemption yield. If we had been given a net redemption yield then it would have been correct to take account of the tax in the cash flows. We are given a gross redemption yield and we should take cash flows without the tax deduction.

 

[Polina Hadjipanayiotou]

The trick lies with the redemption yield. If we had been given a net redemption yield then it would have been correct to take account of the tax in the cash flows. We are given a gross redemption yield and we should take cash flows without the tax deduction.

Thank you very much for this, helped a lot - but my new question is for part ii) b), for this part we took account of the tax in the cash flows though.

 

[Mark Mitchell]

In (ii)(b), we are asked for the "annual effective rate of return earned by the first investor". Since we know that the first investor pays tax on coupons at 25%, the rate of return the investor actually earns will be the net (ie after tax) return.

 

[Polina Hadjipanayiotou]

In (ii)(b), we are asked for the "annual effective rate of return earned by the first investor". Since we know that the first investor pays tax on coupons at 25%, the rate of return the investor actually earns will be the net (ie after tax) return.

Great thanks