Question

Problem 1-10 (LO. 4, 5)

Ashley runs a small business in Boulder, Colorado, that makes snow skis. She expects the business to grow substantially over the next three years. Because she is concerned about product liability and is planning to take the company public in year 2, she currently is considering incorporating the business. Pertinent financial data are as follows:

Year 1 Year 2 Year 3 Sales revenue $150,000 $320,000 $600,000 Tax-free interest income 5,000 8,000 15,000 Deductible cash expenses 30,000 58,000 95,000 Tax depreciation 25,000 20,000 40,000

Ashley expects her combined Federal and state marginal income tax rate to be 25% over the three years before any profits from the business are considered. Her after-tax cost of capital is 10%, and the related present value factors are: for 2017, 0.8929; for 2018, 0.7972; and for 2019, 0.7118.

Click here to access the tax table to use for this problem.

Enter all amounts as positive numbers. When required, round your answers to the nearest dollar.

a. Considering only these data, compute the present value of the future cash flows for the three-year period, assuming that Ashley incorporates the business and pays all after-tax income as dividends (for Ashley’s dividends that qualify for the 15% rate).

	Year1	Year2	Year3
Taxable Income	?	?	?
Corporate tax liability	?	?	?
Cash available for dividends beforetaxes	?	?	?
Less: corporate tax liability	?	?	?
Equals: cash available for dividends aftertaxes	?	?	?
Less: tax on dividend at 15% rate	?	?	?
After-tax cash flow	?	?	?
Present value of cash flow	?	?	?

Considering only these data, compute the present value of the future cash flows for the period, assuming that Ashley continues to operate the business as a sole proprietorship.

	Year 1			Year 2			Year 3
Taxable income	?			?			?
Individual tax liability	?			?			?
Cash available for withdrawals beforetaxes	?			?			?
Less: individual tax liability	?			?			?
Equals: cash available for withdrawals after taxes	?			?			?
Present value of cash flow	?			?			?

Answer 1

a. Computation of Taxable Income, Corporate Tax Liability and PV of cash flow Amount in $

Particular	Year 1	Year 2	Year 3
Sales Revenue	150000	320000	600000
Less: Deductible Cash Expenses	30000	58000	95000
Less: Tax Depreciation	25000	20000	40000
Taxable Income	95000	242000	465000
Corporate Tax Liability @ 25%	23750	60500	116250
Taxable Income	95000	242000	465000
Add: Tax Free Interest Income	5000	8000	15000
Add: Tax Depreciation	25000	20000	40000
Cash available for Dividends before Taxes	125000	270000	520000
Less: Corporate Tax liability	23750	60500	116250
Cash available for Dividends after Taxes	101250	209500	403750
Less: Tax on dividend @ 15%	15188	31425	60563
After tax cash flow	86062	178075	343188
PV factors	0.8929	0.7972	0.7118
Present Value of cash flow	76845	141961	244281

b. Computation of Taxable Income, Individual Tax Liability and PV of cash flow Amount in $

Particular	Year 1	Year 2	Year 3
Sales Revenue	150000	320000	600000
Less: Deductible Cash Expenses	30000	58000	95000
Less: Tax Depreciation	25000	20000	40000
Taxable Income	95000	242000	465000
Individual Tax Liability @ 25%	23750	60500	116250
Taxable Income	95000	242000	465000
Add: Tax Free Interest Income	5000	8000	15000
Add: Tax Depreciation	25000	20000	40000
Cash available for Withdrawals before Taxes	125000	270000	520000
Less: Individual Tax Liability @ 25%	23750	60500	116250
Cash available for Withdrawals After Taxes	101250	209500	403750
PV factors	0.8929	0.7972	0.7118
Present Value of cash flow	90406	167013	287389

Note: Assuming Combined Federal and State marginal income tax rate 25% is both for corporate and Individuals