Question

1. Explain the purpose of forgetting sunk costs when calculating FCF. Provide an example.  

2. Discuss a progressive tax system. What is the difference between a firm’s marginal and average tax rates? Explain.

Answer 1

1: Sunk costs are those costs which have already been incurred and the consideration of which will not make any difference to the decision-making process. Hence they are irrelevant and should not be taken into account. For example: a sum of $10000 was spent on conducting a feasibility study for a particular project. This amount has already been incurred and hence only the future cash flows from the project will be considered for decision-making. This amount is the relevant to the decision-making process.

2: A progressive taxation system is one in which higher taxes are levied at higher income levels. Hence higher the income, the higher the rate of tax.

The marginal tax refers to the tax rate charged at the additional dollar earned up. The average tax on the other hand is the total tax amount/ total taxable income. This can be understood with the help of an example. A person has an income of $1000. He is charged tax as follows:

10% on $600 = 60

20% on $400 = $80

Total tax = $140

In the above example, the marginal tax is 20% while the average tax = 140/1000= 14%