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 4.5 percent ($22,500 annual before-tax cash flow). The return on Investment A is taxable, whereas the return on Investment B is tax exempt. Firm L forecasts that its 35 percent marginal tax rate will be stable for the foreseeable future.

a. Compute the explicit tax and implicit tax that Firm L will pay with respect to Investment A and Investment B.

b-1. What is the annual after-tax cash flow for Investment A?

b-2. What is the annual after-tax cash flow for Investment B?

b-3. Which investment results in the greater annual after-tax cash flow?

Answer 1

Investment	500,000
Annual Return before tax	30,000
Explicit Tax(35%)	10,500

1
Explicit Tax	Taxes Paid to Government
Explicit Tax	30000*35%
Explicit Tax	10,500

Implicit Tax	Taxes paid through higher prices or lower returnson tax favored instruments
Implicit Tax Rate	(Fully-Taxed Return - Tax-free Return)/Fully Taxed Return
Implicit Tax Rate	(30000-22500)/30000
Implicit Tax Rate	25%
Implicit Tax	30000*25%
Implicit Tax	7,500

B1
Annual After-Tax Cash Flow	30000*0.65	19,500

B2
Annual After-Tax Cash Flow		22,500

B3- Investment B will result in greater annual after-tax cash flow.

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