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Mr. A, who has a 35 percent marginal tax rate, must decide between two investment opportunities,...

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 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, determine which investment has the greater NPV.

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Answer #1

Investment 1:

Annual After-Tax Cash Flow = Before-tax cash flow(1 - t) + Annual Fee

= $8,000(1 - 0.35) + $200 = $4,800 + 200 = $5,000

NPV = PV of Cash Inflow - PV of Cash Outflow

= $5,000/1.061 + $5,000/1.062 + $55,000/1.063 - $50,000

= $4,716.98 + $4,449.98 + $46,179.06 - $50,000

= $5,346.02

Investment 2:

Cash Flow in Year 3 = Sale Price - Tax on capital gain

= $75,000 - ($25,000 x 0.15) = $75,000 - $3,750 = $71,250

NPV = PV of Cash Inflow - PV of Cash Outflow

= $71,250/1.063 - $50,000

= $59,822.87 - $50,000

= $9,822.87

Investment 2 has the greater NPV.

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