Question

French Corporation wishes to hire Leslie as a consultant to design a comprehensive staff training program. The project is expected to take one year, and the parties have agreed to a tentative price of $77,000. French Corporation has proposed payment of one-half of the fee now, with the remainder paid in one year when the project is complete. Use Appendix A and Appendix B.

Required:

1. a. If Leslie expects her marginal tax rate to be 15 percent this year and 25 percent next year, calculate the after-tax net present value of this contract to Leslie, using a 6 percent discount rate.
2. b. French Corporation expects its marginal tax rate to be 21 percent both years. Calculate the net present value of French’s after-tax cost to enter into this contract using a 6 percent discount rate.
3. c-1. Given that Leslie expects her tax rate to increase next year, she would prefer to receive more of the income from the project up front. Consider an alternative proposal under which French pays Leslie $54,000 this year, and $21,000 in one year when the contract is complete. Calculate the after-tax benefit of this counterproposal to Leslie and the after-tax cost to French.
4. c-2. Are both parties better off under this alternative than under the original plan?

Answer 1

Solution

we will use discount factor PRESENT VALUE OF $1 for n = 1 year i = 6%

= [1/1.06]¹

=0.943

Year 0
Cash received	38,500	77000*1/2
Tax cost	-5775	15%
Net cash flow	32725	38500-5775
Year 1
Cash received	38500
Tax cost	-9625	25%
Net cash flow	28875
discount factor(6%)	0.943
Present value of year 1 cash flow	27229	[28875*0.943]
NPV	59954	[32775+27229]

Req b.

Year 0
Cash paid	-38,500	77000*1/2
Tax cost	8085	21%
Net cash flow	-30415	-38500+8085
Year 1
Cash paid	-38500
Tax cost	8085	21%
Net cash flow	-30415
discount factor(6%)	0.943
Present value of year 1 cash flow	-28681	[30415*0.943]
NPV	-59096	[30415+28681]

Req c-1

restructured to leslie
Year 0
Cash received	54000
Tax cost	-8100	15%*54000
Net cash flow	45900	54000-8100
Year 1
Cash received	21000
Tax cost	-5250	25%*21000
Net cash flow	15750
discount factor(6%)	0.943
Present value of year 1 cash flow	14852	[15750*0.943]
NPV	60752	[45900+14852]

restructured for french
Year 0
Cash paid	-54000
Tax cost	11340	21%
Net cash flow	-42660	-54000+11340
Year 1
Cash paid	-21000
Tax cost	4410	21%
Net cash flow	-16590
discount factor(6%)	0.943
Present value of year 1 cash flow	-15644	[-16590*0.943]
NPV	-58304	-42660-15644

REQC-2

yes both the company are better off with option c1 as the cash outflow of french reduces and cash inflow of leslie increases.

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