2. (13 points) Assume that a firm pays taxes on revenue and is allowed some dedu

Question

2. (13 points) Assume that a firm pays taxes on revenue and is allowed some deductions.

a. (3 points) Derive and explain the user cost of capital if the firm's nominal interest payments are tax deductible.

b. (2 points) Derive and explain the user cost of capital if the firm's real interest payments are tax deductible.

c. (3 points) Derive and explain the user cost of capital if the depreciation of capital is tax deductible.

d. (2 points) Derive and explain the user cost of capital if the firm's real interest payments and the depreciation of capital are tax deductible.

e. (3 points) What is the impact of the tax on the firm's desired level of capital in the last case?

Explanation / Answer

a. the payment of interest amount can be deductable, then the firm will pay less amount as tax. because from the profits it has to deduct interest payment before it pay tax to government.

b. the same happens here also, the payment of interest is deductable then payment of tax will be less in this case.

c. the firm should deduct depreciation amount from its revenues and next, payment of taxes; once if both these deducted the payment of tax comes down.

for example: a firm revenue is $1000, and tax rate is 30%. if there are no depreciation and taxes, it has to pay $300 tax to government. in other case assume that it deduct $300 as depreciation, and $100 as interest. then total deductions are $400, and on remaining $600 only tax should paid. i.e. 600*0.3= $180 only, so the payment of tax comes down.

e. even the firm can increase the amount of capital if they need.

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