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

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 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.

a. Calculate Net present value of Investment 1.

Calculate Net present value of Investment 1. (Enter cash outflows with a minus sign. Round discount factor(s) to 3 decimal places.)

b. Calculate Net present value of Investment 2.

Calculate Net present value of Investment 2. (Enter cash outflows with a minus sign. Round discount factor(s) to 3 decimal places.)

Explanation / Answer

NPV = $9822.87

After Tax cashflow for year 1 = 8000 * (1 - tax rate ) - 200 = 5000

Similarly for year 2 = 5000

And for year 3 = 50000 + 5000 = 55000

In investment 2 after tax cash floe for year 1 and 2 is 0

In year 3 = 50000 + 25000*(1 - capital gain tax rate) = $71250

Year 0 1 2 3 After tax cashflow -50000 5000 5000 55000 Present Value -50000 4716.98 4449.9822 46179.06 NPV $5346.024 Year 0 1 2 3 After tax cashflow -50000 0 0 71250 Present Value -50000 0 0 59822.87

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