Question

Ashley runs a small business that makes snow skis. She expects the business to grow substantially over the next three years. Because she is concerned about product liability and is planning to take the company public in year 2, she currently is considering incorporating the business. Pertinent financial data are as follows:

Year 1 Year 2 Year 3 Sales revenue $150,000 $320,000 $600,000 Tax-free interest income 5,000 8,000 15,000 Deductible cash expenses 30,000 58,000 95,000 Tax depreciation 25,000 20,000 40,000

Ashley expects her combined Federal and state marginal income tax rate to be 25% over the three years before any profits from the business are considered. Assume that the corporation will face a flat 21% Federal corporate income tax and no state income tax. Ashley’s after-tax cost of capital is 10%, and the related present value factors are: for 2018, 0.8929; for 2019, 0.7972; and for 2020, 0.7118.

Additional Info about tax table

Income Tax Rates—Corporations Taxable income The Tax is: But not Over- Of the Amount Over- 0 Over- 0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 15% $ 7,500 + 25% 13,750 + 34% 22,250 + 39% 113,900 + 34% 3,400,000 + 35% 5,150,000 + 38% 35% 50,000 75,000 100,000 335,000 10,000,000 15,000,000

Enter all amounts as positive numbers. When required, round your answers to the nearest dollar.

a. Considering only these data, compute the present value of the future cash flows for the three-year period, assuming that Ashley incorporates the business and pays all after-tax income as dividends (for Ashley’s dividends that qualify for the 15% rate).

Year 1 Year 2 Year 3 Taxable income $ $ $ Corporate tax liability $ $ $ Cash available for dividends before taxes $ $ $ Less: corporate tax liability $ $ $ Equals: cash available for dividends aftertaxes $ $ $ Less: tax on dividend at 15% rate $ $ $ After-tax cash flow $ $ $ Present value of cash flow $ $ $

b. Considering only these data, compute the present value of the future cash flows for the period, assuming that Ashley continues to operate the business as a sole proprietorship.

Year 1 Year 2 Year 3 Taxable income $ $ $ Individual tax liability $ $ $ Cash available for withdrawals beforetaxes $ $ $ Less: individual tax liability $ $ $ Equals: cash available for withdrawals after taxes $ $ $ Present value of cash flow $ $ $

c. Should Ashley incorporate the business in year 1?

Answer 1

Part A

	Year 1	Year 2	Year 3
Taxable income	95000	242000	465000
Corporate tax liability	19950	50820	97650
Cash available for dividend before taxes	125000	270000	520000
Less corporate tax liability	19950	50820	97650
Equals: cash available for dividends after taxes	105050	219180	422350
Less: tax on dividend at 15% rate	15758	32877	63353
After-tax cash flow	89292	186303	358997
Present value of cash flow	79729	148521	255534

Corporate tax liability = taxable income * 21%

tax on dividend = cash available for dividends after taxes*15%

Present value of cash flow = After-tax cash flow * PV factor 0.8929 for year 1, 0.7972 for year 2, 0.7118 for year 3.

Part B

	Year 1	Year 2	Year 3
Taxable income	95000	242000	465000
Individual tax liability	23750	60500	116250
Cash available for withdrawals before taxes	125000	270000	520000
Less: individual tax liability	23750	60500	116250
Equals: cash available for withdrawals after taxes	101250	209500	403750
Present value of cash flow	90406	167013	287389

Individual tax liability = taxable income * 25%

Present value of cash flow = cash available for withdrawals after taxes * PV factor 0.8929 for year 1, 0.7972 for year 2, 0.7118 for year 3.

Part C

No, Ashley should not incorporate business in year 1 (the present value of cash inflows in year 1 is higher in case of sole proprietorship)