Question

Roger, who is in the 32% marginal tax bracket, must decide between two investment opportunities, both of which require an initial cash outlay of $60,000 at the beginning of year 1. Investment A: This investment will yield $9,000 before-tax cash flow at the end of years 1, 2 and 3. This cash represents ordinary taxable income. At the end of year 3, Roger can liquidate the investment and recover his $60,000 cash outlay. He must pay a nondeductible (for tax purposes) $500 annual fee at the end of years 1, 2, and 3 to maintain Investment A. Investment B: This investment will not yield any before-tax cash flow during the period over which Roger will hold the investment. At the end of year 3, Roger will be able to sell Investment B for $82,000 cash. His $22,000 profit on the sale will be a capital gain. Required: Assuming a 6% discount rate and end-of-year tax payments, determine which investment has the greater net present value.

Answer 1

Net Present Value for Investment A

Year	Particulars	Before tax	After Tax
0	Initial Investment	-60000	-60000
1-3	Cash flow	9000	6120*
1-3	Annual Fees	-500	-340**
3	Recover amount	60000	40800***
	Net Present Value		-13420

*9000(1-0.32) = 6120 **500(1-0.32) = 340 ***60000(1-0.32) = 40800

Net Present Value for Investment B

Year	Particulars	Before tax	After Tax
0	Initial Investment	-60000	-60000
1-3	Cash flow	0	0
1-3	Annual Fees	0	0
3	Recover amount	82000	55760*
	Net Present Value		-4240

*82000(1-0.32) = 55760

• Investment B is better investment.