tax rate

when do you use marginal tax rate vs average tax rate? i am referring to a question from qbank on calculating diluted eps. when calculating net income they use average tax rate and when calculating the interest expense on a convertable bond they use marginal tax rate… is this just a rule? should it always be done this way?

Look at it logically. When they give you pretax income, tax expense, and net income do you really care or need to know that the first $50K of pretax income was taxed at this rate, the next $25K at a different rate, etc, stepping thru all of the different tiers? (hint, the answer is no). That’s why you get the average tax rate. When you are are adjusting pretax income you need to know the specific rate (ie marginal rate) that will be applied to that specific item.

Super, this was a good to explain that, I am clear on it now. Also, on a completely different note… I head somewhere that dividends paid by the company are taxed at marginal tax rate, but the (realized) capital gain from selling the shares are taxed at some lower rate? - Dinesh S

Dinesh, you are right that dividents and capital gains are taxed differently. There are a couple of variables here. One is the country tax law and the other one is the investor tax bracket. You will read more about it in the equity valuation materials.

Dinesh, this should be addressed in the dividend policy section of your books. In the U.S., from the perspective of a shareholder, prior to 2003, one relative advantage of a share repurchase by the company vs. a payment of dividends was that long-term capital gains were taxed at 20%, whereas dividends were taxed as ordinary income at the investor’s marginal tax rate (often higher than 20%). Since 2003, both long-term capital gains and dividends have been taxed equally at 15% for most investors. Your books will elaborate, and even Wikipedia has some good stuff on this.

thanks now i understand it better