Question

hemingway corporation is considering expanding its operations to boost its income, but before making a final decision, it has asked you to calculate the corpo-rate tax consequences of such a decision. currently, hemingway generates before-tax yearly income of $200,000 and has no debt outstanding. expanding operations would allow hemingway to increase before-tax yearly income to $350,000. hemingway can use either cash reserves or debt to finance its expansion. of hemingway uses debt, it will have a yearly interest expense of $70,000. create a spreadsheet to conduct a tax analysis (assume a 21% flat tax rate) for hemingway corporation and determine the following:

a. what is hemingway’s current annual corporate tax liability?

b. what is hemingway’s current average tax rate?

c. if hemingway finances its expansion using cash reserves, what will be its new corporate tax liability and average tax rate?

d. if hemingway finances its expansion using debt, what will be its new corporate tax liability and average tax rate?

e. what would you recommend the firm do? why?

Tax Schedule =

Taxable income brackets		Base tax		+	(Marginal rate X amount over bracket lower limit)
$	0 to $50,000	$	0	+	(15% X amount over $ 0)
50,000 to 75,000		$	7,500	+	(25% X amount over $ 50,000)
75,000 to 100,000		$	13,750	+	(34% X amount over $ 75,000)
100,000 to 335,000		$	22,250	+	(39% X amount over $ 100,000)
335,000 to 10,000,000		$	113,900	+	(34% X amount over $ 335,000)
10,000,000 to 15,000,000		$	3,400,000	+	(35% X amount over $ 10,000,000)
15,000,000 to 18,333,333		$	5,150,000	+	(38% X amount over $ 15,000,000)
Over 18,333,333		$	6,416,667	+	(35% X amount over $ 18,333,333)

Answer 1

a. Current annual corporate tax liability can be found using the corporate tax rate schedule:

Before tax income $ 200,000

Tax liability ($22,250 + $39,000) $61,250

b. Current average tax rate = $61,250 / $200,000 = 30.63%

c. If hemingway finances its expansion using cash reserves, the new corporate tax liability and average tax rate​ is as under, using the corporate tax rate schedule:

Before tax income $ 350,000

Tax liability ($113,900 + $5,100) $ 119,000

Average tax rate = $119,000/$350,000 = 34%

d. If hemingway finances its expansion using debt, the new corporate tax liability and average tax rate is as under, using the corporate tax rate schedule:

Before tax income $ 350,000

less: Interest expense ($ 70,000)

Taxable income $ 280,000

Tax liability ($22,250 + $70,200) $ 92,450

Average tax rate = $92,450/$280,000 = 33.02%

e.  The after tax income from each possibility given below should be considered & the choice with the highest after tax income should be recommended:

Current after tax income = $200,000 - $61,250 = $138,750

Expansion with cash reserve, after tax income = $350,000 - $119,000 = $231,000

Expansion with debt, after tax income = $280,000 - $92,450 + $70,000 = $257,550

Hence, the third option with $257,550 after tax income is recommended.