Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sol

Question

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 40 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments.

a. What is the after-tax cost if Isabel pays the $20,000 bill in December?

b. What is the after-tax cost if Isabel pays the $20,000 bill in January? Use Exhibit 3.1

https://ezto-cf-media.mheducation.com/Media/Connect_Production/bne/accounting/spilker_10e/exhibit3_1.png

Explanation / Answer

A. she received a bill of $20000 bill in December:$20000

tax deduction × 40 percent marginal tax rate = $8000in present value tax savings.

After-tax cost= Pretax cost - present value tax saving
= $20000 - $8000 = $12000

b.she pay in January
Pay $20000 bill in January:$20000

tax deduction × 40 percent marginal tax rate = $8000 in tax savings in one year.
Present Value of Tax Savings= $8000 × .926 (Discount Factor, 1 Year, 12 percent)= $7143

After-tax cost= Pretax Cost Present Value Tax Savings= $20000 $7143 = $12857

c.
Pay $20000 in December is the clear winner. giving her payment in January will increase the cash outflow.

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