Concept explainers
a.
Calculate
a.
Explanation of Solution
Calculate NPV of salary received by Mrs. X.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | $80,000 | $80,000 | $80,000 | |
Less: Tax cost | $(20,000) | $(32,000) | $(32,000) | |
After-tax cash flow | $60,000 | $48,000 | $48,000 | |
Multiply: Discount factor at 8% | - | |||
Present value | $60,000 | $44,448 | $41,136 | $145,584 |
Working note:
Calculate tax cost.
Year 1 | Year 2 | Year 3 | |
Before-tax income | $80,000 | $80,000 | $80,000 |
Multiply: Marginal tax rate | |||
Tax cost | $20,000 | $32,000 | $32,000 |
Hence, the NPV of salary received by Mrs. X is $145,584.
Calculate NPV of salary cost to Firm B.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | -$80,000 | -$80,000 | -$80,000 | |
Add: Tax savings | $27,200 | $27,200 | $27,200 | |
After-tax cash flow | -$52,800 | -$52,800 | -$52,800 | |
Multiply: Discount factor at 8% | - | |||
Present value | -$52,800 | -$48,893 | -$45,250 | -$146,943 |
Working note:
Calculate tax savings.
Year 1 | Year 2 | Year 3 | |
Before-tax deduction | -$80,000 | -$80,000 | -$80,000 |
Multiply: Marginal tax rate | |||
Tax savings | -$27,200 | -$27,200 | -$27,200 |
Hence, the NPV of salary cost to Firm B is -$146,943.
b.
Calculate net present value (NPV) of salary received by Mrs. X and NPV of salary cost to Firm B.
b.
Explanation of Solution
Calculate NPV of salary received by Mrs. X.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | $140,000 | $50,000 | $50,000 | |
Less: Tax cost | $(35,000) | $(20,000) | $(20,000) | |
After-tax cash flow | $105,000 | $30,000 | $30,000 | |
Multiply: Discount factor at 8% | - | |||
Present value | $105,000 | $27,780 | $25,710 | $158,490 |
Working note:
Calculate tax cost.
Year 1 | Year 2 | Year 3 | |
Before-tax income | $140,000 | $50,000 | $50,000 |
Multiply: Marginal tax rate | |||
Tax cost | $35,000 | $20,000 | $20,000 |
The NPV of salary received by Mrs. X is $158,490.
Calculate NPV of salary cost to Firm B.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | -$140,000 | -$50,000 | -$50,000 | |
Add: Tax savings | $47,600 | $17,000 | $17,000 | |
After-tax cash flow | -$92,400 | -$33,000 | -$33,000 | |
Multiply: Discount factor at 8% | - | |||
Present value | -$92,400 | -$30,558 | -$28,281 | -$151,239 |
Working note:
Calculate tax savings.
Year 1 | Year 2 | Year 3 | |
Before-tax deduction | -$140,000 | -$50,000 | -$50,000 |
Multiply: Marginal tax rate | |||
Tax savings | -$47,600 | -$17,000 | -$17,000 |
c.
Calculate net present value (NPV) of cost to Firm B under the proposal and state whether the proposal is superior to its original offer.
c.
Explanation of Solution
Calculate NPV of cost to Firm B under the proposal.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | -$140,000 | -$45,000 | -$45,000 | |
Add: Tax savings | $47,600 | $15,300 | $15,300 | |
After-tax cash flow | -$92,400 | -$29,700 | -$29,700 | |
Multiply: Discount factor at 8% | - | |||
Present value | -$92,400 | -$27,502 | -$25,453 | -$145,355 |
Working note:
Calculate tax savings.
Year 1 | Year 2 | Year 3 | |
Before-tax deduction | -$140,000 | -$45,000 | -$45,000 |
Multiply: Marginal tax rate | |||
Tax savings | -$47,600 | -$15,300 | -$15,300 |
Hence, NPV of cost to Firm B under the proposal is -$145,355.
Comment: The proposal is superior to its original offer as the NVP of salary cost of the proposal (-$145,355) is lower than the NVP of salary cost of the original offer (-$146,943).
d.
State whether Mrs. X should accept the original offer or the counterproposal by calculating net present value (NPV) of salary received.
d.
Explanation of Solution
Calculate NPV of salary received by Mrs. X.
Year 0 | Year 1 | Year 2 | NPV | |
Before-tax cash flow | $140,000 | $45,000 | $45,000 | |
Less: Tax cost | $(35,000) | $(18,000) | $(18,000) | |
After-tax cash flow | $105,000 | $27,000 | $27,000 | |
Multiply: Discount factor at 8% | - | |||
Present value | $105,000 | $25,002 | $23,139 | $153,141 |
Working note:
Calculate tax cost.
Year 1 | Year 2 | Year 3 | |
Before-tax income | $140,000 | $45,000 | $45,000 |
Multiply: Marginal tax rate | |||
Tax cost | $35,000 | $18,000 | $18,000 |
Comment: Mrs. X should accept the counterproposal as the NPV of salary received of the proposal ($153,141) is higher than the NVP of salary received of the original offer ($145,584).
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Chapter 3 Solutions
Loose Leaf for Principles of Taxation for Business and Investment Planning 2019 Edition
- During the last five months of the year, Dwana opens a new Internet telecommunications business called Dwan-Com. Dwan-Com bills 50,000 of revenues, but receives only 40,000 cash. Dwan-Com incurs 3,000 of supply expenses, and 41,000 of labor costs. Dwan-Com pays for 2,200 of the supplies and 38,000 of the labor costs in the current year. a. What is Dwan-Coms taxable income if it elects the cash method of accounting? b. What is Dwan-Coms taxable income if it elects the accrual method of accounting? c. What method of accounting do you recommend that Dwan-Com elect?arrow_forwardIn each of the following problems, identify the tax issue(s) posed by the facts presented. Determine the possible tax consequences of each issue that you identify. Ariel has worked for Sander Corporation for 30 years. Sander has a pension plan in which it matches employee contributions by up to 5 percent of the employees salary. Ariel, who is single, retires during the current year when she is 66 years old. Her pension plan contains payments and earnings of 300,000, half of which are attributable to payments made by Ariel and half attributable to payments made by Sander. Under the plan, Ariel is to receive 2,000 per month until she dies.arrow_forwardFloyd, a cash basis taxpayer, has received an offer to purchase his land. The cash basis buyer will pay him either 100,000 at closing or 50,000 at closing and 56,000 two years after the date of closing. If Floyd recognizes the entire gain in the current year, his marginal tax rate will be 25% (combined Federal and state rates). However, if he spreads the gain over the two years, his combined marginal tax rate on the gain will be only 20%. Floyd does not consider the buyer a credit risk, and he understands that shifting the gain to next year with an installment sale will save taxes. Still, he realizes that the deferred payment will, in effect, earn only 6,000 for waiting two years for the other 50,000. Floyd believes he can earn a 10% before-tax rate of return on his after-tax cash. Floyds adjusted basis for the land is 25,000, the buyer is also a cash basis taxpayer, and the short-term Federal rate is 4%. Floyd has asked you to evaluate the two alternatives on an after-tax basis.arrow_forward
- Individual Income TaxesAccountingISBN:9780357109731Author:HoffmanPublisher:CENGAGE LEARNING - CONSIGNMENT