3. You may use the following simplified corporate tax bracket to answer the foll
ID: 1192694 • Letter: 3
Question
3. You may use the following simplified corporate tax bracket to answer the following question:
Range
Tax
$0 - $5,000
10% of the amount over $0
$5,000 - $20,000
$500 + 20% of the amount over $5,000
$20,000 - $25,000
$3,500 + 40% of the amount over $20,000
$25,000 and over
30% of the amount over $0
You’re the Chief Operating Officer for Space X, and your current taxable corporate income is $24,000. You can undertake a project that will increase your taxable corporate income by $1,500. The project costs $500. Explain your answers to the following questions thoroughly and be sure to address how the given tax code affects your choices.
a.Do you undertake this project if you are able to finance the project without raising funds?
b.Now suppose that you need to raise the $500 through either debt or equity financing, and the interest rate is 10%. Interest paid on loans is deductible, and you can claim a credit for dividend payments. Do you undertake the project? How do you finance it? Why?
Range
Tax
$0 - $5,000
10% of the amount over $0
$5,000 - $20,000
$500 + 20% of the amount over $5,000
$20,000 - $25,000
$3,500 + 40% of the amount over $20,000
$25,000 and over
30% of the amount over $0
Explanation / Answer
In current scenario, total tax for the company is
3500+(4000*0.4) = 5100
Now, if company is able to finance its cost internally and if we assume that the taxable income rises by 1500 even after deducting the cost then it will fall into highest tax structure that is
25500*0.3 = 7650
This is clearly not beneficial.
Now if company decided to finance it then debt financing should be preferred. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases.
The decision hinges on the tax bracket as taxable income going above 25000 is not beneficial and will lead to rejecting the project. While, keeping it below or at 25000 is beneficial and that too with debt financing as interest cost are deductible while dividend on equity is not.
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