Question

Mr. A, who has a 35 percent marginal tax rate, must decide between two investment opportunities, both of which require a $50,000 initial cash outlay in year 0. Investment 1 will yield $8,000 before-tax cash flow in years 1, 2, and 3. This cash represents ordinary taxable income. In year 3, Mr. A can liquidate the investment and recover his $50,000 cash outlay. He must pay a nondeductible $200 annual fee (in years 1, 2, and 3) to maintain Investment 1. Investment 2 will not yield any before-tax cash flow during the period over which Mr. A will hold the investment. In year 3, he can sell Investment 2 for $75,000 cash. His $25,000 profit on the sale will be capital gain taxed at 15 percent. Assume a 6 percent discount rate. Use Appendix A and Appendix B. a. Calculate net present value of Investment 1. b. Calculate net present value of Investment 2. c. Which investment has the greater NPV? Complete this question by entering your answers in the tabs below. Required A Required B Required C Calculate net present value of Investment 1. (Enter cash outflows with a minus sign. Round discount factors to 3 decimal places and final answers to nearest whole dollar amount.) NPV of after-tax cash flow YO NPV of after-tax cash flow Y1 NPV of after-tax cash flow Y2 NPV of after-tax cash flow Y3 NPV of after-tax cash flow, YO to Y3 Required A Required B Required c Calculate net present value of Investment 2. (Enter cash outflows with a minus sign. Round discount factors to 3 decimal places and final answers to nearest whole dollar amount.) NPV of after-tax cash flow YO NPV of after-tax cash flow Y1 NPV of after-tax cash flow Y2 NPV of after-tax cash flow Y3 NPV of after-tax cash flow, YO to Y3

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Answer 1

Investment-1
						6.00%
Year	Initial cash flow	Operating before tax profit	Tax @ 35%	Other payments	Cash Flow	PV factor = 1/ (1+r)^t	PV
0	(50,000)		-	-	(50,000)	1.000	(50,000.00)
1		8,000	(2,800)	(200)	5,000	0.943	4,716.98
2		8,000	(2,800)	(200)	5,000	0.890	4,449.98
3		8,000	(2,800)	(200)	5,000	0.840	4,198.10
3	50,000		-		50,000	0.840	41,980.96
						NPV	5,346.02
Investment-2
						6.00%
Year	Initial cash flow	Cap Gain	Tax @ 15%		Cash Flow	PV factor = 1/ (1+r)^t	PV
0	(50,000)		-		(50,000)	1.000	(50,000.00)
1			-		-	0.943	-
2			-		-	0.890	-
3	75,000	25,000	(3,750)		71,250	0.840	59,822.87
						NPV	9,822.87
As we can see NPV in investmetn-2 is higher