Question

Mr. A, who has a 35 percent marginal tax rate, must decide between two investment opportunities, both of which require a $50,000 initial cash outlay in year 0. Investment 1 will yield $8,000 before tax cash flow in years 1, 2, and 3. This cash represents ordinary taxable income. In year 3, Mr. A can liquidat the investment and recover his $50,000 cash outlay. He must pay a non deductible $200 annual fee (in years 1, 2, and 3) to maintain Investment 1.

Investment 2 will not yield any before-tax cash flow during the period over which Mr. A will hold the investment. In year 3, he can sell investment 2 for $75,000 cash. His $25,000 profit on the sale will be capital gain taxed at 15 percent. Assuming a 6 percent discount rate. Use Appendix A and Appendix B.

a) Calculate Net present value of investment 1

b) Calculate Net present value of investment 2

After Tax Cashflow Y0
After Tax Cashflow Y1
After Tax Cashflow Y2
After Tax Cashflow Y3
NPV of After Tax Cashflow Y0 to Y3

c) Which investment has the greater NPV?

Answer 1