Question

1. Mr. Hewitt is deciding between two investment opportunities: Investment A and Investment B. Both investments will require an initial nondeductible cash outlay of $100,000 in 2020 (the current year). Other relevant details on each investment are as follows:

   • Investment A will provide Mr. Hewitt with annual pretax income of $14,000 in each of the following three years: 2021, 2022, and 2023. This income will be taxable to Mr. Hewitt at his ordinary income tax rate of 35%. Mr. Hewitt can then recover his initial investment of $100,000 in 2023 tax-free. Mr. Hewitt must also pay a non-deductible investment advisory fee of $500 per year in 2021, 2022, and 2023 to maintain Investment A.

   • Investment B will not provide any annual income to Mr. Hewitt after he makes his initial investment. However, Mr. Hewitt can sell Investment B in 2023 for $130,000. Any gain on this sale will be taxed at Mr. Hewitt’s long-term capital gains tax rate of 15%.

     Assuming a discount rate of 7%, which investment maximizes the NPV of Mr. Hewitt’s post-tax investment income – and by how much? Support your answer with clearly labeled calculations.

Answer 1

Investment A is more favorable for Mr Hewitt as its NPV is $ 1,753.52 more in post - tax income than Investment B. The calculations are as follows:

Post-tax income of investment
Investment A	$     4,198.91
Investment B	$     2,445.38
Income in A in excess of B (Inv A - Inv B)	$     1,753.52

Investment A
Discount rate - 7%	7%
Cash flow type	Amount	Year	Period	Calculation of NPV Formula: Cash flow/((1+Discount rate)^Number of periods)	NPV
Initial investment - outflow	$       (100,000)	2020	0	-$ 100,000 / ((1 + 0.07)^0)	$ (100,000.00)
Cash inflow net of tax (14,000*(1-tax rate), i.e. 14,000*65%)	$              9,100	2021	1	$ 9,100 / ((1 + 0.07)^1)	$        8,504.67
Cash outflow of non-deductible investment advisory fee	$                (500)	2021	1	-$ 500/ ((1 + 0.07)^1)	$          (467.29)
Cash inflow net of tax (14,000*(1-tax rate), i.e. 14,000*65%)	$              9,100	2022	2	$ 9,100 / ((1 + 0.07)^2)	$        7,948.29
Cash outflow of non-deductible investment advisory fee	$                (500)	2022	2	-$ 500/ ((1 + 0.07)^2)	$          (436.72)
Cash inflow net of tax (14,000*(1-tax rate), i.e. 14,000*65%)	$              9,100	2023	3	$ 9,100 / ((1 + 0.07)^3)	$        7,428.31
Cash outflow of non-deductible investment advisory fee	$                (500)	2023	3	-$ 500/ ((1 + 0.07)^3)	$          (408.15)
Recovery of initial investment (tax free) - inflow	$          100,000	2023	3	$ 100,000 / ((1 + 0.07)^3)	$      81,629.79
Net Present Value of Investment (Total)					$        4,198.91

Investment B
Discount rate - 7%	7%
Cash flow type	Amount	Year	Period	Calculation of NPV Formula:Cash flow/((1+Discount rate)^Number of periods)	NPV
Initial investment - outflow	$       (100,000)	2020	0	-$ 100,000 / ((1 + 0.07)^0)	$ (100,000.00)
Sale value of investment - inflow	$          130,000	2023	3	$ 130,000 / ((1 + 0.07)^3)	$    106,118.72
Capital gains tax on capital gain - outflow
($130,000 - $100,000)*15%	$            (4,500)	2023	3	-$ 4,500 / ((1 + 0.07)^3)	$      (3,673.34)
Net Present Value of Investment (Total)					$        2,445.38