Question

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $41,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $41,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 6 percent on her investments. a. What is the after-tax cost if Isabel pays the $41,000 bill in December? After-tax cost b. What is the after-tax cost if Isabel pays the $41,000 bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.) After-tax cost

Answer 1

a) After Tax Cost, if Isabel pays the bill $41000 in December :

Bill Amount = $ 41000

Less: Tax Saving = 41000*37% = $15170

After Tax Cost = $25830

Note: On payment of an expense, there will be saving in tax which will reduce the effective cost of that expense.

b) After Tax Cost, if Isabel pays the bill $41000 in January :

Bill Amount = $ 41000

Less: Tax Saving = 41000*37% = $15170

Less: Return on Investment @ 6% for one month  = 41000*6%*1/12 = $205

After Tax Cost = $25625

Note1 : On payment of an expense, there will be saving in tax which will reduce the effective cost of that expense.

Note 2 : We are assuming that Isabel will pay the bill at the end of January and therefore he will be eligible for Interest on Investment for one month .

Note 3: Return on Investment is an income and will reduce the net Cost of the expense.

Note 4: we are given the rate of Return of investment as 6% so we are assuming that is for annum, therfore, we divide it by 12 to get one month rate of return . Alternatively we can assume it for one month then the Return of investment anount would be 41000*6% = $ 2460 ( Although this alternative is not practically possible)

Note 5. We are given 6% rate of return after considering tax effect. Therefore we will deduct it from after tax effective cost of bill.

C) On the based of above wo alternative a) and b) , it is advisable for Isabel to choose Option b) that is pay in January , it will cost less to her by $205.