Question

Firm W, which has a 30 percent marginal tax rate, plans to operate a new business that should generate $50,000 annual cash flow/ordinary income for three years (years 0, 1, and 2). Alternatively, Firm W could form a new taxable entity (Entity N) to operate the business. Entity N would pay tax on the three-year income stream at a 20 percent rate. The nondeductible cost of forming Entity N would be $6,000. Firm W uses a 6 percent discount rate. Use Appendix A and Appendix B.

Required:

1. Complete the below tables to calculate NPV.
2. Should it operate the new business directly or form Entity N to operate the business?

Answer 1

Solution:

Business operated by Firm W

Particulars Year 0 Year 1 Year 2

After tax cash flow at 30% tax rate (50,000 X 70% ) $ 35000   $ 35000   $ 35000

Discount Factor (6%) 1 0.943 0.890

Present Value $ 35000 $ 33005 $ 31150

NPV $ 99,155

Business operated by Firm N

After tax cash flow at 20% tax rate(50,000 X 80%) $ 40000 $ 40000   $ 40000

Cost of Forming Entity N -6000 0 0

Net Cash Flow $ 34000 $ 40000 $ 40000

Discount Factor (6%) 1 0.943 0.890

Present Value $ 34000 $ 37720 $ 35600

NPV   $ 107,320

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