Amanda, who is in the 32% marginal tax bracket, must decide between two investme
ID: 2331216 • Letter: A
Question
Amanda, who is in the 32% marginal tax bracket, must decide between two investment opportunities, both of which require an initial cash outlay of $150,000 at the beginning of year 1.
Investment A: This investment will yield $25,500 before-tax cash flow at the end of years 1, 2 and 3. This cash represents ordinary taxable income. At the end of year 3, Amanda can liquidate the investment and recover her $150,000 cash outlay. She must pay a nondeductible (for tax purposes) $750 annual fee at the end of years 1, 2, and 3 to maintain Investment A.
Investment B: This investment will not yield any before-tax cash flow during the period over which Amanda will hold the investment. At the end of year 3, Amanda will be able to sell Investment B for $215,000 cash. Her $65,000 profit on the sale will be a capital gain.
Required: Assuming a 6% discount rate and end-of-year tax payments, determine which investment has the greater net present value.
Explanation / Answer
Investment A
Cash Inflow
CPV of Cash Inflow (25500*2.67) 68085
PV of Investment at 3rd year (150000*0.839) 125850
Total Cash inflow 193935
(-) Tax @32% 62059.20
Cash inflow after tax 131875.80
(-) CPV of Annual Fees (750*2.67) 2002.50
Net Cash Inflow 129873.30
Cash Outflow
Purchase of Investment 150000
Net Present Value (20126.70)
Investment B
Cash Inflow
Pv of Sale of investment (215000*0.839) 180835
Cash Outflow
Purchase of Investment 150000
PV of Tax on Capital Gain(65000*32%*0.839) 17451.20
Total Cash Outflow 167451.20
Net Present Value 12933.80
Investment B is a better Option.
*CPVF Cumulative Present value Factor
*PV Present Value
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