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 4.8 percent ($24,000 annual before-tax cash flow). The return on Investment A is taxable, while the return on Investment B is tax exempt. Firm L forecasts that its 21 percent marginal tax rate will be stable for the foreseeable future.

Required:

1. a. Compute the explicit tax and implicit tax that Firm L will pay with respect to Investment A and Investment B.
2. b-1. What is the annual after-tax cash flow for Investment A?
3. b-2. What is the annual after-tax cash flow for Investment B?
4. b-3. Which investment results in the greater annual after-tax cash flow?

Answer 1

CALCULATION OF EXPLICIT TAX

FORMULA

BEFORE TAX RETURN X MARGINAL RATE OF TAX

INVESTMENT A

= 30000 $ X 21 %

= 6300 $

INVESTMENT B

= 24000 $ X 0 % (as INVETSMENT B is Tax Exempt)

= 0 $

CALCULATION OF IMPLICIT TAX

DEFINATION OF IMPLICIT TAX -

It is Obiouse that return under Tax Favoured Option will be Lower than the Fully Taxable Options. The Difference in Before Tax returns under Both the options is called Implicit Tax. As this loss in before Tax Return under Tax Favoured option does not go to The State, thus this is called Implicit Tax.

FORMULA OF IMPLICIT TAX -

= Before Tax Return under Fully Taxable Option LESS Before Tax Return under Tax Favoured Option

IMPLICIT TAX IN INVETSMENT A

= 0 $ (as this is Fully Taxable Option)

IMPLICIT TAX IN INVETSMENT B

= Before Tax Return under Invetsment A LESS  Before Tax Return under Invetsment B

= 30000 $ - 24000 $

= 6000 $

Answer to Requirement A

INVESTMENT A INVESTMENT B

EXPLICIT TAX 6300 $ 0 $

IMPLICIT TAX 0 $ 6000 $

B1 - ANNUAL AFTER TAX CASH FLOW IN INVESTMENT A

BEFORE TAX CASH FLOW  LESS EXPLICIT TAX

= 30000 $ - 6300 $

= 23700 $ AFTER TAX CASH FLOW

B2 - ANNUAL AFTER TAX CASH FLOW IN INVESTMENT B

BEFORE TAX CASH FLOW  LESS EXPLICIT TAX

= 24000 $ - 0 $

= 24000 $ AFTER TAX CASH FLOW

(Before and After Tax Cash Flow are Same in INVESTMENT B as this is Tax Exempt)

B3 - WHICH INVESTMENT RESULTS IN THE GREATER ANNUAL AFTER TAX CASH FLOW

INVETSMENT B HAVE GREATER AFTER TAX CASH FLOW OF 24000 $ AS COMPARED TO INVETSMENT A HAVING 23700 $ ONLY.

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