Question

Problem 1-10 (LO. 4, 5)

Ashley runs a small business in Boulder, Colorado, 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 35% over the three years before any profits from the business are considered. Her after-tax cost of capital is 10%, and the related present value factors are: for 2016, 0.8929; for 2017, 0.7972; and for 2018, 0.7118.

Click here to access the tax table to use for this problem.

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

a. Considering only this 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).

2016 2017 2018 Taxable income $ $ $ Corporate tax liability $ $ $ Cash available for dividends before taxes $ $ $ Less: corporate tax liability $ $ $ Equals: cash available for dividends after taxes $ $ $ Less: tax on dividend at 15% rate $ $ $ After-tax cash flow $ $ $ Present value of cash flow $ $ $

b. Considering only this 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.

2016 2017 2018 Taxable income $ $ $ Individual tax liability $ $ $ Cash available for withdrawals before taxes $ $ $ 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?

Income Tax Rates—Corporations Taxable income The Tax Is: But not Over- Of the Amount Over- 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

Please show calculations.

Answer 1

Part A

	Year 1	Year 2	Year 3
Taxable income	95000	242000	465000
Corporate tax liability	20550	77630	158100
Cash available for dividend before taxes	125000	270000	520000
Less corporate tax liability	20550	77630	158100
Equals: cash available for dividends after taxes	104450	192370	361900
Less: tax on dividend at 15% rate	15668	28856	54285
After-tax cash flow	88782	163514	307615
Present value of cash flow	$79273	$130353	218960

Taxable income = Sales revenue - Deductible cash expenses - Tax depreciation

Corporate tax liability

Year 1 = 13750+(34%*(95000-75000)) = 20550

Year 2 = 22250+(39%*(242000-100000)) = 77630

Year 3 = 113900+(34%*(465000-335000)) = 158100

Cash available for dividend before taxes = Sales revenue –(Deductible cash expenses- Tax-free interest income)

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	33250	84700	162750
Cash available for withdrawals before taxes	125000	270000	520000
Less: individual tax liability	33250	84700	162750
Equals: cash available for withdrawals after taxes	101250	209500	403750
Present value of cash flow	$81924	$147721	$254291

Individual tax liability = taxable income * 35%

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