Question

Firm E must choose between two alternative transactions. Transaction 1 requires a $10,000 cash outlay that would be nondeductible in the computation of taxable income. Transaction 2 requires a $17,400 cash outlay that would be a deductible expense. Determine the after-tax cost for each transaction. Assume Firm E’s marginal tax rate is 25 percent. Determine the after-tax cost for each transaction. Assume Firm E’s marginal tax rate is 45 percent.

Answer 1

Marginal tax rate is the rate at which tax is incurred on an additional dollar of income. In the United States, the federal marginal tax rate for an individual increases as income rises. This method of taxation, known as progressive taxation, aims to tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher-income earners. While many believe this is the most equitable method of taxation, many others believe this discourages business investment by removing the incentive to work harder.

Answer of PART A - Marginal tax @ 25%

Transaction 1

After tax cost - $10,000

No tax is deducted from because questions has said that the transaction is nondeductible in computation of taxable income. Hence, tax is not deducted and the given cost become the after tax cost.

Transaction 2

After tax cost = cost - marginal tax

After tax cost = $17,400 - (25% of $17,400)

After tax cost = $17,400 - $4,350

After tax cost = $13,050

Transaction 1 has the lesser after tax cost.

Answer of Part B - Marginal rate @ 45%

Transaction 1

After tax cost - $10,000

No tax is deducted from because questions has said that the transaction is nondeductible in computation of taxable income. Hence, tax is not deducted and the given cost is become after tax cost.

Transaction 2

After tax cost = cost - marginal tax

After tax cost = $17,400 - (45% of $17,400)

After tax cost = $17,400 - $7,830

After tax cost = $9,570

Transaction 2 has the lesser after tax cost.