Question

Firm L has $500,000 to invest and is considering two alternatives. Investment A would pay 6 percent ($30,000 annual before-tax cash flow). Investment B would pay 4.5 percent ($22,500 annual before-tax cash flow). The return on Investment A is taxable, whereas the return on Investment B is tax exempt. Firm L forecasts that its 35 percent marginal tax rate will be stable for the foreseeable future.

a. Compute the explicit tax and implicit tax that Firm L will pay with respect to Investment A and Investment B.

b-1. What is the annual after-tax cash flow for Investment A?

b-2. What is the annual after-tax cash flow for Investment B?

Answer 1

EXPLANATION --- PART A

Compute the explicit tax and the implicit tax that Firm L will pay with respect to Investment A and Investment B Explicit = 10,500, Implicit = 7,500 Calculation -- Explicit Þ 30,000 * 6% Implicit Þ (6% - 4.5%) * 500,000

EXPLANATION PART B ---

b-1 ---- Investment A – After tax cash flows – 30000-35% == 19500 b-2 ----Investment B – After tax cash flows ==22500 Investment B results in the greater annual after-tax cash flow