In: Finance
Steve has a house and lot for sale for $70, 000. It is estimated
that $10,000 is the value of the land and $60 000 is the value of
the house. Annthea is purchasing the house on January 1 to rent and
plans to own the house for 5 years. After 5 years, it is expected
that the house and land can be sold on December 31 for $80,000
($20,000 for the land and $60,000 for the house). Total annual
expenses (maintenance, property taxes, insurance, etc.) are
expected to be $3000 a year. The house would be depreciated using a
CCA rate of 10%. Annthea wants a 15% after-tax rate of return on
her investment. You may assume that Annthea has an incremental
income tax rate of 27% in each of the 5 years. Capital gains are
taxed at 13.5%. Determine the following:
(a) The annual depreciation.
(b) The capital gain (loss) resulting from the sale of the
house.
(c) The annual rent Annthea must charge to produce an after-tax
rate of return of 15%.
Greetings,
1) Annual depreciation is as under on reducing balance basis -
Usually land is not depreciable as land has infinite life. Therefore depreciation is to be applied only on 60000.
Year 1 = 60000*0.10 = 6000
Year 2 = (60000-6000)*0.1 = 5400
Year 3 = (54000-5400)*0.10 = 4860
Year 4 = (48600-4860)*0.10 = 4374
Year 5 = (43740-4374)*0.10= 3937
2) WDV at the end if 5 years = (70000 - 6000 -5400 -4860 - 4374 - 3937) = 45429
Sale price = 80000
Therefore capital gain = 80000 - 45429 = 34571
Tax on capital gain = 34571 * 0.135 = 4667
3) Annual depreciation tax shield (DTS) is as under -
Y 1 = 6000 * 0.27 = 1620
Y 2 = 5400 * 0.27 = 1458
Y 3 = 4860 * 0.27 = 1312
Y 4 = 4374 * 0.27 = 1181
Y 5 = 3937 * 0.27 = 1063
PV of DTS @15% = 4578
Annual after tax expenses = 3000*(1-0.27) = 2190
PV of expenses @15% = 7341
Annuity factor for 5 years @15% on after tax basis = 7341/2190 = 3.352
Initial Outlay = 70000
Post tax salvage value = 80000 -4667 = 75333
PV of SV = 75333/(1.15)^5 = 37454
Let after annual rental being = x
So PV of rental = 3.352x
At 15% rate of return, annual rental can be calculated as under -
Initial Outflow = Annual Rental + DTS + Post tax SV - Annual after tax expenses
70000 = 3.352x + 4578 + 37454 - 7341
x = 1053
This is on after tax basis. But before tax rental is given by
10534/(1-0.27) = 14430