CFIN 3 3rd Edition by Besley – Test Bank

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

Chapter 5 —The Cost of Money (Interest Rates)

TRUE/FALSE

1. The nominal rate of interest is defined as the sum of the nominal risk-free rate of return and the expected inflation rate.

ANS:  F

r_Nom = r_RF + DRP + LP + MRP.

DIF:    Easy               TOP:   Interest rates

2. If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

ANS:  T                    DIF:    Easy               TOP:   Interest rates

3. The term structure is defined as the relationship between interest rates and maturities of similar securities.

ANS:  T                    DIF:    Easy               TOP:   Term structure of interest rates

4. During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) often are prevalent.

ANS:  T                    DIF:    Easy               TOP:   Yield curve

5. The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.

ANS:  T                    DIF:    Easy               TOP:   Term structure theories

6. The fact that a percentage of the interest income received by one corporation is excluded from taxable income has encouraged firms to use more debt financing relative to equity financing.

ANS:  F                    DIF:    Easy               TOP:   Interest income

7. If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant.

ANS:  F                    DIF:    Easy               TOP:   Interest expense

8. The real rate of interest is composed of a risk-free rate of interest plus a premium that reflects the riskiness of the security.

ANS:  F                    DIF:    Easy               TOP:   Interest rates

9. The yield curve is downward sloping, or inverted, if the long-term rates are higher than the short-term rates.

ANS:  F                    DIF:    Easy               TOP:   Yield curve

10. The liquidity preference theory states that each borrower and lender has a preferred maturity and that the slope of the yield curve depends on supply and demand for funds in the long-term market relative to the short-term market.

ANS:  F                    DIF:    Easy               TOP:   Term structure theories

11. If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to borrow money, it should probably issue long-term rather than short-term debt.

ANS:  T                    DIF:    Medium         TOP:   Term structure of interest rates

12. The two reasons most experts give for the existence of a positive maturity risk premium are (1) because investors are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer to borrow short.

ANS:  F                    DIF:    Medium         TOP:   Term structure theories

13. An investor with a six-year investment horizon believes that interest rates are determined only by expectations about future interest rates, (i.e., this investor believes in the expectations theory). This investor should expect to earn the same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another 3-year bond three years from now (ignore transaction costs).

ANS:  T                    DIF:    Medium         TOP:   Term structure theories

14. The existence of an upward sloping yield curve proves that the liquidity preference theory is correct, because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to lend for longer periods.

ANS:  F                    DIF:    Medium         TOP:   Term structure theories

15. Suppose financial institutions, such as savings and loans, were required by law to make long-term, fixed interest rate mortgages, but, at the same time, were largely restricted, in terms of their capital sources, to deposits that could be withdrawn on demand. Under these conditions, these financial institutions should prefer a “normal” yield curve to an inverted curve.

ANS:  T                    DIF:    Medium         TOP:   Yield curve

16. Investors with a higher time preference for consumption will demand a lower rate of return to forego current consumption and save than investors with a lower time preference for consumption.

ANS:  F                    DIF:    Medium         TOP:   Cost of money

17. Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand.

ANS:  T                    DIF:    Medium         TOP:   Interest rates

18. Bonds with higher liquidity will demand higher interest rates in the market since they can be easily converted into cash on short notice at or near the fair market value for that bond.

ANS:  F                    DIF:    Medium         TOP:   Interest rates

MULTIPLE CHOICE

1. Which of the following statements is most correct? Other things held constant.

a.	the “liquidity preference theory” would generally lead to an upward sloping yield curve.
b.	the “market segmentation theory” would generally lead to an upward sloping yield curve.
c.	the “expectations theory” would generally lead to an upward sloping yield curve.
d.	the yield curve under “normal” conditions would be horizontal (i.e., flat).
e.	a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

 

ANS:  A

The liquidity preference theory states that investors prefer shorter-maturity bonds to longer maturities, other things (like interest rates) held constant. That preference arises because long-term bonds are exposed to more interest rate risk than short-term bonds. In any event, the liquidity preference theory would lead to an upward sloping yield curve.

DIF:    Easy               OBJ:   TYPE: Conceptual    TOP:   Term structure of interest rates

2. Your uncle would like to restrict his interest rate risk and his default risk, but he still would like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle’s criteria?

a.	AAA bond with 10 years to maturity.
b.	BBB perpetual bond.
c.	BBB bond with 10 years to maturity.
d.	AAA bond with 5 years to maturity.
e.	BBB bond with 5 years to maturity.

 

ANS:  D                    DIF:    Easy               OBJ:   TYPE: Conceptual    TOP:    Risk and return

3. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

a.	The yield on the 10-year bond is less than the yield on a 1-year bond.
b.	The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.
c.	It is impossible to tell without knowing the coupon rates of the bonds.
d.	The yields on the two bonds are equal.
e.	It is impossible to tell without knowing the relative risks of the two bonds.

 

ANS:  A                    DIF:    Easy               OBJ:   TYPE: Conceptual    TOP:    Yield curve

4. If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?

a.	Investors expect short-term rates to be constant over time.
b.	Investors expect short-term rates to increase in the future.
c.	Investors expect short-term rates to decrease in the future.
d.	It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
e.	The maturity risk premium must be positive.

 

ANS:  C                    DIF:    Easy               OBJ:   TYPE: Conceptual

TOP:   Term structure theories

5. Which of the following statements is correct?

a.	For the most part, our federal tax rates are progressive, because higher incomes are taxed at higher average rates.
b.	Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light.
c.	Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d.	Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations.
e.	All of the above statements are true.

 

ANS:  E                    DIF:    Easy               OBJ:   TYPE: Conceptual

TOP:   Taxes and financing

6. Which of the following is not one of the four fundamental factors that affect the cost of money?

a.	production opportunities
b.	time preferences for consumption
c.	risk
d.	liquidity
e.	inflation

 

ANS:  D                    DIF:    Easy               OBJ:   TYPE: Conceptual    TOP:    Cost of money

7. Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7% respectively. Assume that the pure expectations theory holds and that the market is in equilibrium. Which of the following statements is most correct?

a.	The maturity risk premium is positive.
b.	Interest rates are expected to rise over the next two years.
c.	The market expects one-year rates to be 5.5% one year from today.
d.	Answers a, b, and c are all correct.
e.	Only answers b and c are correct.

 

ANS:  B

r = r_RF  + DRP + LP + MRP. For Treasury securities, DRP and LP are equal to zero. Further, MRP is only appropriate for long-term bonds; since these Treasury securities are short-term securities, MRP is close to zero.

Therefore, statement a is false. Statement c is false because

where x equals one-year Treasury rates one year from today. If you solve this equation, you will find that x = 7%, not 5.5%. As a result, statement b is the only correct statement.

DIF:    Medium         OBJ:   TYPE: Conceptual               TOP:   Expectations theory

8. If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

a.	Prices and interest rates will both rise.
b.	Prices will rise and interest rates will decline.
c.	Prices and interest rates will both decline.
d.	Prices will decline and interest rates will rise.
e.	There will be no changes in either prices or interest rates.

 

ANS:  D                    DIF:    Medium         OBJ:   TYPE: Conceptual

TOP:   Security transactions

9. Assume that the current yield curve is upward sloping, or normal. This implies that

a.	Short-term interest rates are more volatile than long-term rates.
b.	Inflation is expected to subside in the future.
c.	The economy is at the peak of a business cycle.
d.	Long-term bonds are a better buy than short-term bonds.
e.	None of the above statements is necessarily implied by the yield curve given.

 

ANS:  E                    DIF:    Medium         OBJ:   TYPE: Conceptual    TOP:    Yield curve

10. Which of the following statements is correct?

a.	The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
b.	Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
c.	According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward.
d.	The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping.
e.	If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

 

ANS:  B                    DIF:    Medium         OBJ:   TYPE: Conceptual

TOP:   Interest rate concepts

11. Allen Corporation can (1) build a new plant which should generate a before-tax return of 11 percent, or (2) invest the same funds in the preferred stock of FPL, which should provide Allen with a before-tax return of 9%, all in the form of dividends. Assume that Allen’s marginal tax rate is 25 percent, and that 70 percent of dividends received are excluded from taxable income. If the plant project is divisible into small increments, and if the two investments are equally risky, what combination of these two possibilities will maximize Allen’s effective return on the money invested?

a.	All in the plant project.
b.	All in FPL preferred stock.
c.	60% in the project; 40% in FPL.
d.	60% in FPL; 40% in the project.
e.	50% in each.

 

ANS:  B

After-tax return on the new project:

0.11(1 – T) = 0.11(0.75) = 0.0825 = 8.25%.

After-tax return on the preferred stock:

0.09[1 – 0.25(0.3)] = 0.08325 = 8.325%.

Therefore, invest 100 percent in the FPL preferred stock.

DIF:    Medium         OBJ:   TYPE: Conceptual               TOP:   After-tax returns

12. The normal yield curve is upward sloping implying that

a.	the return on short-term securities are higher than the return on long-term securities of similar risk.
b.	the return on long-term securities are equal to the return on short-term securities of similar risk.
c.	the return on short-term securities are lower than the return on long-term securities of similar risk.
d.	the return on bonds with a higher default risk is higher than the returns on bonds with lower default risk.
e.	the return on bonds with a lower default risk is higher than the returns on bonds with higher default risk.

 

ANS:  C                    DIF:    Medium         OBJ:   TYPE: Conceptual    TOP:    Yield curve

13. Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6 percent, and Carter’s marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would make Carter’s treasurer indifferent between the two?

a.	2.40%
b.	3.60%
c.	4.50%
d.	5.25%
e.	6.00%

 

ANS:  B

Chicago municipal bonds = Tax Exempt; BT yield = AT yield.

U.S. Treasury bonds = AT yield = 6%(1 – 0.4) = 3.60%.

3.60% = yield where indifferent between the two.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   After-tax yield

14. As a corporate investor paying a marginal tax rate of 34 percent, if 70 percent of dividends are excludable, what would be your after-tax dividend yield on preferred stock with a 16 percent before-tax dividend yield?

a.	6.36%
b.	7.36%
c.	12.19%
d.	13.01%
e.	14.37%

 

ANS:  E

16%[1 – 0.34(0.30)] = 14.368% » 14.37%.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   After-tax returns

15. Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% each of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be 0.1%(t – 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest?

a.	0.25%
b.	0.50%
c.	1.00%
d.	1.75%
e.	2.50%

 

ANS:  E

IP₆ = [5%(3) + 6%(3)]/6 = 5.5%.

MRP = 0.1%(t – 1) = 0.1%(5) = 0.5%.

r_RF = r^* + MRP + IP

8.5% = k^* + 0.5% + 5.5%

k^* = 2.5%.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   Real risk-free rate of interest

16. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?

a.	9.0%
b.	9.5%
c.	10.0%
d.	10.5%
e.	11.0%

 

ANS:  A

r₂ = (r₁ in Year 1 + r₁ in Year 2)/2

10.5% = (12% + r₁ in Year 2)/2

r₁ in Year 2 = 9%.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   Expected interest rates

17. Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively. What is the average expected inflation rate over this 5-year period?

a.	6.5%
b.	7.5%
c.	8.0%
d.	6.0%
e.	7.0%

 

ANS:  E

IP₅ = (4% + 7% + 10% + 8% + 6%)/5 = 7%.

Note: The geometric average is 6.981%, which rounds to 7%.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   Average inflation

18. Your corporation has the following cash flows:

 

Operating income	$250,000
Interest received	10,000
Interest paid	45,000
Dividends received	20,000
Dividends paid	50,000

 

If the applicable income tax rate is 40 percent, and if 70 percent of dividends received are exempt from taxes, what is the corporation’s tax liability?

a.	$74,000
b.	$88,400
c.	$91,600
d.	$100,000
e.	$106,500

 

ANS:  B

Operating income	$250,000
Interest received	10,000
Interest paid	(45,000)
Dividends received (taxable)	6,000*
Taxable income	$221,000

^*$20,000(0.30) = $6,000.

Taxes = 0.4($221,000) = $88,400.

DIF:    Easy               OBJ:   TYPE: Problem                    TOP:   Corporate taxes

19. Assume that r^* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t – 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t – 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

a.	0.25%
b.	0.50%
c.	0.63%
d.	1.00%
e.	1.13%

 

ANS:  E

r* = 1.0%

MRP = 0.2% (10-1) = 1.8%

DRP = 0.07% (9) = 0.63%

LP = 0.5%

 

r_it = r* + IP_t + DRP_t + LP_t + MRP_t

rATT	=	1.0%	+	4.6%	+	0.63%	+	0.5%	+	1.8%	=	8.53%
rT-Bond	=	1.0%	+	4.6%	+	0%	+	0%	+	1.8%	=	7.40%
Difference												1.13%

 

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   Expected interest rates

20. You are given the following data:

 

r* = real risk-free rate	4%
Constant inflation premium	7%
Maturity risk premium	1%
Default risk premium for AAA bonds	3%
Liquidity premium for long-term T-bonds	2%

 

Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the nominal risk-free rate for T-bills is __________, and the rate on long-term Treasury bonds is __________.

a.	4%; 14%
b.	4%; 15%
c.	11%; 14%
d.	11%; 15%
e.	11%; 17%

 

ANS:  C

Nominal risk-free rate:

r_RF = r^* + IP = 4% + 7% = 11%.

T-bond rate:

r_RF = r^* + IP + DRP + LP + MRP = 4% + 7% + 0% + 2% + 1% = 14%.

Note that there is no default premium on a Treasury security.

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   Interest rates

21. You read in The Wall Street Journal that 30-day T-bills currently are yielding 8 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:

 

Inflation premium	5%
Liquidity premium	1%
Maturity risk premium	2%
Default risk premium	2%

 

Based on these data, the real risk-free rate of return is

a.	0%
b.	1%
c.	2%
d.	3%
e.	4%

 

ANS:  D

T-bill rate = r^* + IP

8% = r^* + 5%

r^* = 3%.

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   Real risk-free rate of interest

22. Assume that a 3-year Treasury note has no maturity premium, and that the real, risk-free rate of interest is 3 percent. If the T-note carries a yield to maturity of 13 percent, and if the expected average inflation rate over the next 2 years is 11 percent, what is the implied expected inflation rate during Year 3?

a.	7%
b.	8%
c.	9%
d.	17%
e.	18%

 

ANS:  B

r_RF = r* + IP

13% = 3% + IP

IP = 10%

Therefore, the average inflation expected over the next 3 years is 10 percent. Using an arithmetic average:

30% = 22% + IP₃

IP₃ = 8%

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   Expected inflation

23. Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year bond is 10 percent, and the current rate on a 3-year bond is 12 percent. If the expectations theory of the term structure is correct, what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average.)

a.	12.0%
b.	16.0%
c.	13.5%
d.	10.5%
e.	14.0%

 

ANS:  B

Term structure theories

 

Security Maturity	Current Rate		r1,Year 1		r2,Year 2		r3,Year 3
1 year	8%		8%
2 year	10%		8%		12%
3 year	12%		8%		12%		?

Calculate r₂, the one-year rate in Year 2:

10% = (8% + r₂)/2

r_s = 12%

Calculate r₃, the one-year rate in Year 3:

12% = (8% + 12% + r_s)/3

36% = 20% + r₃

r₃ = 16%

DIF:    Medium         OBJ:   TYPE: Problem         TOP:   Expected inflation

24. Assume that the real risk-free rate, r^*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP₅ – MRP₂?

a.	2.1%
b.	1.8%
c.	5.0%
d.	3.0%
e.	2.5%

 

ANS:  A

First, note that we will use the equation r_t = 4% + IP_t + MRP_t. We have the data needed to find the IPs:

IP₅ = (9% + 6% + 4% + 4% + 4%)/5 = 27%/5 = 5.4%.

IP₂ = (9% + 6%)/2 = 7.5%.

Now we can substitute into the equation:

r₅ = 4% + 5.4% + MRP = 12%.

r₂ = 4% + 7.5% + MRP = 12%.

Now we can solve for the MRPs, and find the difference:

MRP₅ = 12% – 9.4% = 2.6%.

MRP₂ = 12% – 11.5% = 0.5%. Difference = (2.6% – 0.5%) = 2.1%.

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   Maturity risk premium

25. Solarcell Corporation has $20,000 which it plans to invest in marketable securities. It is choosing between AT&T bonds which yield 11%, State of Florida municipal bonds which yield 8%, and AT&T preferred stock with a dividend yield of 9%. Solarcell’s corporate tax rate is 40%, and 70% of the preferred stock dividends it receives are tax exempt. Assuming that the investments are equally risky and that Solarcell chooses strictly on the basis of after-tax returns, which security should be selected? Answer by giving the after-tax rate of return on the highest yielding security.

a.	8.46%
b.	8.00%
c.	7.92%
d.	9.00%
e.	9.16%

 

ANS:  B

Florida muni bond

After-tax yield on FLA bond = 8%. (The munis are tax exempt.)

AT&T bond

After-tax yield on AT&T bond = 11% – Taxes = 11% – 11%(0.4) = 6.6%.

Alternate solution: AT&T bond

Invest $20,000 @ 11% = $2,200 interest.

Pay 40% tax, so after-tax income = $2,200(1 – T) = $2,200(0.6) = $1,320.

After-tax rate of return = $1,320/$20,000 = 6.6%.

AT&T preferred stock

After-tax yield = 9% – Taxes = 9% – 0.3(9%)(0.4) = 9% – 1.08% = 7.92%.

Therefore, invest in the Florida muni bonds which yield 8% after taxes. Note: this problem can be made harder by asking for the tax rate that would cause the company to prefer the AT&T bonds or the preferred stock.

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   After-tax yield

26. A 9 percent coupon bond issued by the State of Pennsylvania sells for $1,000 and thus provides a 9 percent yield to maturity. What yield on a Synthetic Chemical Company bond would cause the two bonds to provide the same after-tax rate of return to an investor in the 28 percent tax bracket?

a.	12.50%
b.	17.50%
c.	7.00%
d.	14.00%
e.	9.00%

 

ANS:  A

Before-tax return(1 – T) = 9%

Before-tax return(0.72) = 9%

Before-tax return = 9%/0.72 = 12.50%.

DIF:    Medium         OBJ:   TYPE: Problem                    TOP:   After-tax returns

27. In 2000, Craig and Kathy Koehler owned a small business which was held as a proprietorship in Kathy’s name. They were thinking of incorporating if that would lower their total tax liability. The Koehlers expected the company to earn $100,000 before taxes next year. They planned to take out a salary of $45,000, and to reinvest the rest in the business. Their personal deductions total $10,750 and if they choose not to incorporate they will file a joint return. (1) What is their expected total tax liability as a proprietorship? (2) As a corporation? (3) Should they incorporate?

a.	$19,393.50; $22,250.00; No
b.	$19,393.50; $13,887.50; Yes
c.	$6,793.50; $6,637.50; Yes
d.	$22,403.50; $15,753.50; Yes
e.	$20,777.50; $22,250.00; No

 

ANS:  B

As a sole proprietorship:

Taxable income
EBT	$100,000
Personal deductions	(10,750)
	$  89,250

 

Tax liability	= $6,457.50 + ($89,250 – $43,050)(0.28)
	= $6,457.50 + $12,936 = $19,393.50

As a corporation:

Taxable income
Salary	$45,000
Personal deductions	(10,750)
1) Personal taxable income	$34,250
2) Company EBT	$55,000

 

1) Personal tax liability = $34,250(0.15)

2) Corporate tax liability + $7,500 + 0.25($55,000 – $50,000)

Total tax liability = $5,137.50 ($7,500 + $1,250) = $13,887.50

Yes, the Koehlers should incorporate.

DIF:    Tough            OBJ:   TYPE: Problem         TOP:   Business organization and taxes