Question

Taxes are costs, and, therefore, changes in tax rates can affect consumer prices, project lives, and the value of existing firms. Evaluate the change in taxation on the valuation of the following project:

	0	1	2	3
1.Initial Investment	100
2. Revenues		100	100	100
3. Cash operating costs		50	50	50
4. Tax depreciation		33.33	33.33	33.33
5. Income pretax		16.67	16.67	16.67
6. Tax at 40%		6.67	6.67	6.67
7. Net income		10	10	10
8. After-tax salvage				15
9. Cash flow (7+8+4-1)	-100	43.33	43.33	58.33
NPV at 20%=0

Assumptions: Tax depreciation is straight-line over three years. Pre-tax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2. Tax on salvage value is 40% of the difference between salvage value and book value of the investment. The cost of capital is 20%.

1. Please verify that the information given above yields NPV = 0.
2. If you decide to terminate the project in year two (2) what would be the NPV of the project?
3. Suppose that the government now changes tax depreciation to allow a 100% write-off in year one (1). How does this affect your answers to parts a and b above?
4. Would it now make sense to terminate the project after two rather than three years?
5. How would your answers change if the corporate income tax were abolished entirely?

Answer 1