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

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 flows in years 1, 2, and 3. This cash
represents ordinary taxable income. In year 3, Mr. A can liquidate
the investment and recover his $50,000 cash outlay. He must pay a
nondeductible $200 annual fee (in years 1, 2, and 3) to maintain...

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