Firm L has $500,000 to invest and is considering two alternatives. Investment A

Question

Firm L has $500,000 to invest and is considering two alternatives. Investment A would pay 6 percent ($30,000 annual before-tax cash flow). Investment B would pay 4.5 percent ($22,500 annual before-tax cash flow). The return on Investment A is taxable, whereas the return on Investment B is tax exempt. Firm L forecasts that its 35 percent marginal tax rate will be stable for the foreseeable future.

a. Compute the explicit tax and implicit tax that Firm L will pay with respect to Investment A and Investment B.

b-1. What is the annual after-tax cash flow for Investment A?

b-2. What is the annual after-tax cash flow for Investment B?

Explanation / Answer

EXPLANATION --- PART A

Explicit = 10,500,

Implicit = 7,500

Calculation --

Explicit Þ 30,000 * 6%

Implicit Þ (6% - 4.5%) * 500,000

EXPLANATION PART B ---

b-1 ---- Investment A – After tax cash flows – 30000-35% == 19500

b-2 ----Investment B – After tax cash flows ==22500

Investment B results in the greater annual after-tax cash flow

1. Compute the explicit tax and the implicit tax that Firm L will pay with respect to Investment A and Investment B

Explicit = 10,500,

Implicit = 7,500

Calculation --

Explicit Þ 30,000 * 6%

Implicit Þ (6% - 4.5%) * 500,000

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