Ms. Pay, who has a 40.8 percent marginal tax rate on interest income (37 percent income tax 3.8 percent Medicare contribution tax), owns HHL Inc. corporate bonds in her investment portfolio. She earned $74,800 interest this year on her HHL bonds.

Compute her after-tax cash flow assuming that:

1. She received two semiannual cash payments of $37,400 each.

2. She instructed HHL to reinvest her interest payments in additional bonds.

3. The entire $74,800 represented the amortization of OID.

After tax cash flow $44,281.60

After tax cash flow ($30,518.40)

After tax cash flow $8856.32

Explanation:

In the first case when the interest income of $74,800, the after-tax cash flow would be taxed as follows"

before tax cash flow $74,800.00

tax at 40.8%*$74,800 ($30,518.40)

After tax cash flow $44,281.60

If the entire interest income is re-invested after tax cash flow is computed thus:

before tax cash flow $0

tax at 40.8%*$74,800 ($30,518.40)

After tax cash flow ($30,518.40)

If the entire interest income represents the original issue discount, which is the difference between the face value and the issue price, after tax cash flow is computed thus:

The OID is taxable as if it accrues over the duration of the investment (bonds), hence a portion of the OID would be assessed to tax each year (assume the duration of investment is 5 years)

Annual portion of OID=$74,800/5

before tax cash flow $14,960.00

tax at 40.8%*$74,800 ($6103.68)

After tax cash flow $8856.32

After tax cash flow $44,281.60