Question 1

Rarke Company must choose between two alternate transactions. Transaction 1 requires a $20,000 nondeductible cash outlay, while transaction 2 requires a $25,000 deductible cash outlay. Determine the marginal tax rate at which the after-tax costs of the two transactions are equal.

Accepted Answer

Let's assume the marginal tax rate is x%.

For transaction 1, the after-tax cost is $20,000 since it's nondeductible.

For transaction 2, the after-tax cost is $25,000 - ($25,000 * x%). This is because the cash outlay is deductible, and the tax savings will depend on the marginal tax rate.

To find the marginal tax rate at which the two transactions have equal after-tax costs, we can set up the following equation:

$20,000 = $25,000 - ($25,000 * x%)

Solving for x%, we get:

x% = 20%

Therefore, at a marginal tax rate of 20%, the after-tax costs of the two transactions would be equal.

Since transaction 2 has a higher deductible cash outlay, it would be the better choice at any marginal tax rate greater than 20%. Therefore, the best choice would be transaction 2.

Question 2

Which of the following statements about different tax rates over time is false?

Accepted Answer

This statement is false because a NPV calculation can incorporate different tax rates over time by using a tax rate schedule or by adjusting the cash flows accordingly. Therefore, a constant tax rate assumption is not always necessary. The other statements are true. Increases or decreases in future taxable income can lead to changes in a firm's future tax rate, and future tax rates used in NPV calculations are estimates because they are subject to potential changes by Congress. Additionally, the timing of a tax rate increase can impact the effect on NPV, as earlier increases have a greater impact on present value than later increases.

Question 3

If a taxpayer decides to take advantage of an ambiguous tax issue to reduce future tax costs, the decision increases:

Accepted Answer

Taking advantage of an ambiguous tax issue increases the audit risk. The IRS may challenge the position taken by the taxpayer, leading to an audit and possible penalties. Choosing this option may not increase financial risk or tax law uncertainty but may increase marginal tax rate uncertainty.

Question 4

Ms. Kent has $200,000 in an investment paying 8% annual interest. Her marginal tax rate is 40%. Which of the following statements is false?

Accepted Answer

A) Ms. Kent's annual before-tax cash flow can be calculated as $200,000 x 8% = $16,000.
B) If the interest is tax-exempt, Ms. Kent's annual after-tax cash flow will still be $16,000 because there would be no tax to pay.
C) If the interest is taxable, Ms. Kent's annual after-tax cash flow will be reduced by the tax amount. The tax payable would be 40% x $16,000 = $6,400, so her after-tax cash flow will be $16,000 - $6,400 = $9,600. Therefore this statement is false.
D) None of the above statements are false except statement C.

Question 5

Holter Inc. owns an investment that generated $120,000 cash revenue and required $26,500 cash expenses this year. Holter's marginal tax rate is 30%. Which of the following statements is false?

Accepted Answer

The answer of Holter Inc. owns an investment that generated...

Question 6

Leto Inc. has $500,000 in an investment paying 8% annual taxable interest. Each year, the corporation incurs a $3,000 nondeductible cash expense relating to the investment. If Leto's marginal tax rate is 35%, compute the annual after-tax cash flow.

Accepted Answer

The answer of Leto Inc. has $500,000 in an investment...

Question 7

Unlow Inc. must choose between two alternate transactions. Transaction 1 would generate $160,000 cash, all of which would be taxable, while transaction 2 would generate $120,000 cash, none of which would be taxable. Determine the marginal tax rate at which the after-tax cash flows from the two transactions are equal.

Accepted Answer

Let x be the marginal tax rate, then we can set up the following equation:

160,000 - 0.4x(160,000) = 120,000

Solving for x, we get:

x = 25%

Therefore, if the marginal tax rate is 25% or higher, transaction 2 would be the better choice since it generates the same amount of cash but is not taxable. If the marginal tax rate is lower than 25%, transaction 1 would be the better choice.

Question 8

Reid Inc. received a $90,000 cash payment, only $50,000 of which was taxable income. If Reid's marginal tax rate is 40%, compute Reid's after-tax cash flow.

Accepted Answer

Reid's after-tax cash flow is $70,000 ($90,000 before-tax cash - $20,000 tax cost on $50,000 income).

Question 9

If Congress enacts a temporary change in the tax law that will apply for only two taxable years, the change increases:

Accepted Answer

A temporary change in tax law creates uncertainty as taxpayers are unsure of whether the law will be extended or changed again in the future. This can lead to difficulties in tax planning and compliance, and increases the overall tax law uncertainty. Market risk, financial risk, and audit risk are not directly impacted by a temporary change in tax law.

Question 10

Ms. Leik has $50,000 in an investment paying 10% annual interest. Each year, she incurs a $600 cash expense relating to the investment. If Ms. Leik's marginal tax rate is 20%, which of the following statements is true?

Accepted Answer

Ms. Leik's annual income from the investment is $5,000 (10% of $50,000). Her annual expense is $600. Therefore, her annual income after expenses is $4,400. 
If Ms. Leik's marginal tax rate is 20%, she will pay $1,000 in taxes on the $5,000 income. Therefore, her annual after-tax cash flow will be $3,400 ($4,400 - $1,000).

Question 11

Mr. Basel made an investment that will generate the following cash flows over a three-year period.  If Mr. Basel's marginal tax rate over the three year period is 20% and he uses a 6% discount rate, compute the NPV of the transaction.

Accepted Answer

The answer of Mr. Basel made an investment that will...

Question 12

Mr. and Mrs. Rath invested in a business that will generate the following cash flows over a three-year period.  If the Raths' marginal tax rate over the three year period is 20% and they use a 6% discount rate, compute the NPV of the transaction.

Accepted Answer

The answer of Mr. and Mrs. Rath invested in a...

Question 13

Hower Inc.'s tax advisor recommends that the corporation take a deduction that the IRS has disallowed for other corporations in similar circumstances. If Hower decides not to take the deduction, it is reducing:

Accepted Answer

The answer of Hower Inc.'s tax advisor recommends that the...

Question 14

XYT Company engaged in a transaction that generated $50,000 cash deposited in the company bank account and required the company to pay $12,000 out of that account. XYT's marginal tax rate is 30%. Which of the following statements is false?

Accepted Answer

Option B is false. If the deposit is taxable income but the payment is nondeductible, the transaction generated $33,800 after-tax cash flow [$50,000 - ($12,000 × (1-0.3)) = $33,800], not $35,000. The other options are true: 
Option A: If the deposit is taxable income and the payment is deductible, the transaction generates $26,600 after-tax cash flow [$50,000 × (1-0.3) - $12,000 = $26,600].
Option C: If the deposit is not taxable income and the payment is nondeductible, the transaction generates $38,000 after-tax cash flow [$50,000 - ($12,000 × 0.3) = $38,000].

Question 15

Mr. Wills invested in a business that will generate $75,000 annual after-tax cash flow in years 0 and 1 and $90,000 annual after-tax cash flow in years 2 and 3. Compute the NPV of these cash flows at a 10% discount rate.

Accepted Answer

The answer of Mr. Wills invested in a business that...

Question 16

Mr. and Mrs. Dean own an investment that generated $60,000 cash revenue and required $12,000 cash expenses this year. The Deans' marginal tax rate is 25%. Which of the following statements is true?

Accepted Answer

The answer of Mr. and Mrs. Dean own an investment...

Question 17

Mrs. Biggs invested in a business that will generate the following cash flows over a three-year period.  If Mrs. Biggs' marginal tax rate over the three year period is 30% and she uses a 6% discount rate, compute the NPV of the transaction.

Accepted Answer

The answer of Mrs. Biggs invested in a business that...

Question 18

Mr. Quest plans to engage in a transaction that will generate $10,000 cash flow in year 0, year 1, and year 2 ($30,000 total cash flow). Which of the following statements is true?

Accepted Answer

If the cash flow is not taxable income, there will be no tax liability and the before-tax and after-tax cash flows will be equal. This also means that there will be no tax implications in the calculation of the NPV, so option B and C are incorrect. Therefore, option A is the correct answer.

Question 19

If Congress enacts legislation late in the year that is retroactive to the beginning of the year, the legislation increases:

Accepted Answer

Retroactive tax legislation can increase tax law uncertainty, making it more difficult for taxpayers to plan and comply with tax obligations. It can also create confusion and increase the likelihood of errors or omissions on tax returns, thereby raising audit risk. However, it does not necessarily impact financial risk or marginal tax rate uncertainty.

Question 20

Ms. Card bought an investment that will generate the following cash flows over a three-year period.  If Ms. Card's marginal tax rate over the three year period is 40% and she uses a 6% discount rate, compute the NPV of the transaction.

Accepted Answer

The answer of Ms. Card bought an investment that will...

Quiz 3: Taxes As Transaction Costs