BU111 Exam-AID Session

Basic Taxation

• You have taxable employment income of $40,000, interest income of $20,000, capital gains of $15,000 and capital losses of $3,000– Calculate your total taxes payable for 2006

Solution

• Total taxable income = 40000 + 20000 + 50%(15000-3000) = $66,000

• Federal Tax = 5548 + 22%(66000-36378) = 12064.84

• Provincial Tax = 2103 + 9.15%(66000-34758) = 4961.64

• Surtax = 20% x 4961.64 = 992.33

• Total Taxes Payable for 2006 = 18018.81

Types of Investment Income

• Interest Income (100% taxable)– Bond interest– REMEMBER: Interest paid to broker in a

“buying on margin” situation is an Interest Cost and is SUBTRACTED from Interest Income

• Dividend Income (Gross up, Tax Credit System)– Dividends on common and preferred shares

• Capital Gains (Net capital gains are 50% taxable)– Sale of shares– Sale of bonds– REMEMBER: NET capital gains are 50% taxable,

so SUBTRACT capital losses

Notation

• 20 KLM 9.5s of 2010

• 30 9% preferred shares of LMN, par value of $150

• 5 XYZ May/32 Calls @ 6

• 10 ABC June/55 Puts– Time value $3– Current market value $51

Stock Quotations in the Financial Press

• 52W 52WHigh Low Div. High Low Close Change Vol (100s)

129.35 103.98 RIM 0.00 126.45 123.21 125.34 -0.44 3,086

• This means that Research in Motion (RIM) common shares have paid no dividends in the past year. The highest price that the shares traded for today was $126.45 per share, and the lowest price was $123.21 per share. The last trade of the day took place at $125.34 per share. This was $0.44 per share lower than the last price they traded at on the previous trading day. On this particular day, 3,086,000 were traded. In the last year (52 weeks) Research in Motion’s shares traded at a high of $129.35 per share and a low of $103.98 per share.

Interest

• You own 10 ABC 8.5s of 2007. ABC pays out its interest on a quarterly basis– Calculate the amount of taxes payable – Assume the investor is in the highest tax

bracket

Solution

• Interest Income = 0.085 x 1000 x 10 bonds x ¼ = $212.50

• Federal Tax = 212.50 x 0.29 = 61.63• Provincial Tax = 212.50 x 0.1116 =

23.72• Surtax = 23.72 x 0.56 = 13.28

• Total Marginal Tax = 98.63

A note about marginal tax rates

• You can calculate marginal tax, like in the previous example (calculating Fed, Prov and Sur separately) OR:

• Apply the combined marginal tax rate• For the highest tax bracket = 29% +

11.16% + (11.16% x 56%) = 46.41%

• Using this marginal tax = 212.50 x 46.41% = $98.62

Dividends

• You own 200 6% cumulative preferred shares of XYZ, par value of $10. XYZ dividends are in arrears for 2 years. Calculate the amount of tax payable. – Assume highest tax bracket

Solution

• Dividend Return = 200 x 6% x 10 par value x 3 years = $360– Dividend Received 360– 45% Gross up 162– Amount subject to tax 522

– Federal tax before credit (29% x 522) 151.38– Less: Fed tax credit (19% x 522) 99.18– Federal tax payable 52.2

– Ontario tax before credit (11.16% x 522) 58.26– Less: Ont tax credit (6.5% x 522) 33.93– Ontario tax payable before Surtax 24.33

– Ontario Surtax (56% x 24.33) 13.62

– TOTAL TAX PAYABLE 90.15

Bonds

• You can purchase ABC Company bonds with a 9% coupon at a price of $104.50. They mature on Oct 31, 2014. Calculate the rough yield. Assume the bond is purchased on Oct 31, 2006 and will be held to maturity

Solution

• (Coupon Rate X Par Value) + (Par Value – Purchase Price) # of years to maturity

Purchase price of bond• = (0.09 X 1000) + (1000 – 1045)

8 1045

• = 8.08%

• Bond prices vary inversely with interest rates– In this case, the bond is selling at a premium (above par), so you

know that the rough bond yield will be an interest rate BELOW the bond’s coupon rate

Bonds

• Assume that you are considering purchasing a QRS bond that has a coupon rate of 12%, which matures Oct 25, 2016. Bonds with similar risk have interest rates of 9%. What is the price of an QRS bond?

Solution

• (Coupon Rate X Par Value) + (Par Value – Purchase Price) # of years to maturity =Bond

Yield Purchase price of bond

• (0.12 x 1000) + [(1000-P)/10] = 0.09 P

• 120 + [(1000-P)/10] = 0.09P• To get rid of the 10 years, multiply every part of the formula by 10• 1200 + 1000 - P = 0.9P• 1200 + 1000 = 1.9P• 2200 = 1.9P• P = 2200/1.9• Price of the bond = 1157.89

Rough Bond Yield

• You need to know this formula (not provided on the midterm exam)

• You also need to know HOW to explain why bond prices vary inversely with interest rates

Effective Tax Rate

• You have capital gains of $5000 and capital losses of $1000.

– Calculate your marginal tax on your net capital gains. (Assume you’re in the 26% tax bracket)

– Calculate your effective tax rate

Solution

• Net capital gains = 50% x (5000 – 1000) = $2,000

• Combined marginal tax rate = 26% + 11.16% + (11.16% x 56%) = 43.41%

• Total taxes payable = 43.41% x 2000 = $868.20

• Effective tax rate = 868.20 x 100% 4000 = 17.36%

• Why is your effective tax rate lower than your combined marginal tax rate?

Bid Vs. Ask Prices

• Bid Price: Represents highest amount that an investor is currently willing to pay to acquire a board lot of shares of a particular bond

• Ask Price: Represents the lowest amount that an investor is willing to accept (sell) for a board lot of shares or a particular bond

• A buyer submitting a market order to buy would pay the current ASK price, and a seller submitting a market order to sell would receive the current BID price

Short Selling

• When you short sell, you are expecting the price of the shares to go down

• Need to keep 150% of the Current Market Value of the shares with your broker

• If the price goes up, you will receive a short call from your broker

Short Selling

• If the price goes down, there will be excess fund in your short account

Short Selling

• On November 1, you short sell 5000 shares of ABC Company. The Bid price is $50 and the Ask price is $55. On December 1, the price of the stock is $60. What would be the amount of the short call?

Solution

• Since you are selling short, you sell the shares at $50 per share (the bid price)– Proceeds = 50 x 5000 = 250,000– Deposit in Short account = 50% x 250000 = 125,000– Therefore on Nov 1, there is $375,000 in your short account

• On Dec 1, the price of the stock goes up. Since you need to keep 150% of the stock’s CMV in your account, you need to deposit additional fund in the account– Should have $450,000 in your short account ($60 x 5000 x

150%)– Therefore you will receive a short call in the amount of

$75000 (450000-375000)

Buying on Margin

• The margin requirement is the percentage of the total investment that you need to contribute (ie: if the margin requirement is 65%, that means that at least 65% of the total investment must be your own money)– The other 35% of your investment would be

loaned to you by a broker

• Once the shares you bought on margin are sold, must repay loan with interest to your broker– Interest rate given will be an annual interest rate

(unless stated otherwise)

Buying on Margin

• When you buy on margin, you expect the stock’s price to increase in the future.

• If the share price goes down, you will receive a margin call from your broker

Buying on Margin

• You are an investor with $10,000 of your own money and you want to buy shares in CLR, which have a Bid price of $23 and an Ask price of $25 per share. By May 1, the price of the stock plummets to $10 per share. Assuming a margin requirement of 40%, what would be your margin call on May 1?

Solution

• 0.40x = 10000x = 25000 (total amount to invest in CLR)– Therefore, borrowing $15000 from broker– 25000/25 = 1000 shares

• CMV has gone down to $10 per share and broker only willing to loan 60%, which results in a margin call of:– =CMV x 60% = (10 x 1000) x 60% = 6000 – Only willing to loan $6000, so you have a margin

call of $9000 (15000-6000)

Options

• Call option Option to buy stock at a certain price (strike price) in the future– Strike Price of $50

• If current market price is $50 At the Money• If current market price is $60 In the Money• If current market price is $45 Out of the Money

• Put option Option to sell stock at a certain price in the future– Strike Price of $20

• If current market price is $35 Out of the Money• If current market price is $15 In the Money• If current market price is $20 At the Money

• Remember that in a question where you purchase an option and exercise it, there will be 3 instances of commissions– Commissions in, out and on the purchase of the option

• Company issues dividends

Put Option

• Purchase a 6 month PUT on 100 Shares of Coca-Cola on May 1 at a cost of $2.90 per share. Exercise Nov 1 a the strike price of $25 per share. The market price on Nov 1 was $21. How much have you made or lost after all costs have been considered.

Solution

• May 1– 100 x 2.90 = $290– Commission = 290 x 2% = $5.8

• Nov 1– Buy = 21 x 100 = 2100

• Commission in = 2100 x 2% = 42

– Sell = 25 x 100 = 2500• Commission out = 2500 x 2% = 50

– Capital Gain/Loss = 2500 – 2100 – 42 – 50 - 5.8 – 290 = $12.20

Call Option

• May 1 Purchase 2 six-month Call options of Nortel at a premium of $3 with a strike price of $44

• July 1 Nortel’s stock decreases to $40

• August 1 Nortel declares dividends of $1 per share

• Sept 1 Nortel’s stock increases to $46– Calculate how much was made or lost after

all the costs have been considered

Solution

• May 1– Cost of Option = 200 x 3 = $600– Commission = 600 x 2% = $12

• July 1– Do nothing because option is out of the money

• Aug 1– You do not own the stock, so you do not have a right to

those dividends• Sept 1

– Buy at strike price = 40 x 200 = 8000• Commission in = 160

– Sell at market price = 46 x 200 = 9200• Commission out = 184

• Capital gain/loss = 9200 – 8000 – 160 – 184 – 600 – 12 = $244

Combined Problems

• Tips– Keep track of dates, money in account,

money on hand, commissions, etc.– Take it one transaction at a time– Highlight key answers– Be comfortable with basic material as well

as transitions between concepts (ex: use excess in short account to…)

Combined Problem

• So far in 2006, you have earned $40,000 in capital gains, $2,000 in interest income and you have $32,000 of taxable employment income. March 1, you sell short 800 shares of Microsoft. The Bid price is $10 and the Ask price is $15. April 1, the price of Microsoft goes to $8. You use the excess in your short account to buy shares of Tim Hortons on margin. Tim Hortons’ market price is $12 per share. The margin requirement is 80% and the interest rate on the loan from your broker is 9%. On May 1, the price of Tim Hortons decreases to $10 and you receive a margin call. On June 1, you sell your shares of Tim Hortons for $24. You use the balance remaining in your margin account to sell short as many Apple shares as possible, with a $53 market price. On July 1, you cover your short position for the Apple and Microsoft shares. On July 1, Apple and Microsoft have selling prices of $50 and $7, respectively.

Calculate total taxes payable for 2006.

Solution to Combined Problem

• March 1, you sell short 800 shares of Microsoft. The Bid price is $10 and the Ask price is $15.– Proceeds = 800 x 10 = 8000

Brokerage out = 8000 x 2% = 160Deposit in short account = 8000 x 50% = 4000Total amount in short account = $12000

Solution to Combined Problem

• April 1, the price of Microsoft goes to $8. You use the excess in your short account to buy shares of Tim Hortons on margin. Tim Hortons’ market price is $12 per share. The margin requirement is 80% and the interest rate on the loan from your broker is 9%.– 800 x 8 x 150% = $9600 needs to be in your account

Excess in short account = 12000 – 9600 = $2400

2400 = 0.80xx = 3000 to invest in totalLoan from broker = 3000 – 2400 = $600

3000/12 = 250 shares of Tim HortonsCommission in = 60

Solution to Combined Problem

• On May 1, the price of Tim Hortons decreases to $10 and you receive a margin call.– CMV = 10 x 250 = 2500

Broker will only lend you 20% of CMV = 500Margin Call = 600-500 = $100

Solution to Combined Problem

• On June 1, you sell your shares of Tim Hortons for $24.– Sell = 250 x 24 = 6000

Commission out = 120Buy = 250 x 12 = 3000Commission in = 60Capital gain = 6000 – 3000 – 120 – 60 = $2820

Interest cost = (600 x 9% x 1/12) + (500 x 9% x 1/12) = $8.25

Solution to Combined Problem

• You use the balance remaining in your margin account to sell short as many Apple shares as possible, with a $53 market price.– Balance in margin account = Proceeds – Commission out –

Loan repayment – Interest Cost= 6000 – 120 – 500 – 8.25= $5371.75

The margin account balance represents your short account deposit with the brokerApple shares = (5371.75 x 2)/53 = 202 sharesBuying 202 shares, you only need to deposit in your short account = 202 x 53 x 50% = $5353(You pocket the additional $18.75)You have an Apple short account balance of $16059.Commissions out = 10706 x 2% = 214.12

Solutions to Combined Problem

• On July 1, you cover you short position for the Apple and Microsoft shares. On July 1, Apple and Microsoft have selling prices of $50 and $7, respectively. – Apple

Sell at 53 x 202 = 10706Commission out = 214.12Buy at 50 x 202 = 10100Commission in = 202Capital Gain = 10706-214.12-10100-202 = $189.88

– MicrosoftSell at 10 x 800 = 8000Commission out = 160Buy at 7 x 800 = 5600 Commission in = 112Capital Gain = 8000-160-5600-112= $2128

Solutions to Combined Problem

• Calculate total taxes payable for 2006.– Capital Gains = 40000 + 2820 + 2128 + 189.88 =

45137.88Taxable Capital Gains = 22568.94

– Interest Income = 2000 – 8.25 = 1991.75– Taxable Employment Income = 32000– Total Taxable Income = $56,560.69

– Federal Tax = 5548 + 22% (56560.69-36378) = 9988.19– Provincial Tax = 2103 + 9.15% (56560.69-34758) =

4097.95– Surtax = 4097.95 x 20% = $819.59

– Therefore Total Tax Payable for 2006 is $14905.73

Tax Tables

Taxable Income Federal Tax on Taxable Income$0 - $36,378 15.25%>$36,378 - $72,756 $5,548 + 22% on next $36,378>$72,756 - $118,285 $13,551 + 26% on next $45,529above $118,285 $25,389 + 29% on remainder

Taxable Income Federal Tax on Taxable Income$0 - $36,378 15.25%>$36,378 - $72,756 $5,548 + 22% on next $36,378>$72,756 - $118,285 $13,551 + 26% on next $45,529above $118,285 $25,389 + 29% on remainder

Table 12006 Federal Tax

Rates

Taxable Income Ontario Tax on Taxable Income0 - $34,758 6.05%$34,758 - $69,517 $2,103 + 9.15% on next $34,759$69,517 and above $5,283 + 11.16% on remainder

Taxable Income Ontario Tax on Taxable Income0 - $34,758 6.05%$34,758 - $69,517 $2,103 + 9.15% on next $34,759$69,517 and above $5,283 + 11.16% on remainder

Table 2 2006 Ontario Provincial Tax

Rates before Surtaxes

Taxable Income Ontario Tax Payable Ontario Surtax Rate$0 - $55,657 $0 - $4,015 0%>$55,657 - $67,139 >$4,015 - 5,066 20%above $67,139 above $5,066 $210 + 56% on remainder

Taxable Income Ontario Tax Payable Ontario Surtax Rate$0 - $55,657 $0 - $4,015 0%>$55,657 - $67,139 >$4,015 - 5,066 20%above $67,139 above $5,066 $210 + 56% on remainder

Table 32006 Ontario Provincial Surtax Rates

Tax Tables II

Federal Ontario OntarioTaxable Income Tax Rate Tax Rate Surtax

0 - $34,758 15.25% 6.05% 0%$ 34,758 - $ 36,378 15.25% 9.15% 0%$ 36,378 - $ 55,657 22.00% 9.15% 0%$ 55,657 - $ 67,139 22.00% 9.15% 20%$ 67,139 - $ 69,517 22.00% 9.15% 56%$ 69,517 - $ 72,756 22.00% 11.16% 56%$ 72,756 - $118,285 26.00% 11.16% 56%$118,285 and above 29.00% 11.16% 56%

Federal Ontario OntarioTaxable Income Tax Rate Tax Rate Surtax

0 - $34,758 15.25% 6.05% 0%$ 34,758 - $ 36,378 15.25% 9.15% 0%$ 36,378 - $ 55,657 22.00% 9.15% 0%$ 55,657 - $ 67,139 22.00% 9.15% 20%$ 67,139 - $ 69,517 22.00% 9.15% 56%$ 69,517 - $ 72,756 22.00% 11.16% 56%$ 72,756 - $118,285 26.00% 11.16% 56%$118,285 and above 29.00% 11.16% 56%

Tax Brackets and Applicable Tax Rates for 2006 (Ontario): Table 4 p.39