Arco ships 15 million barrels of refined oil monthly from Arco-Canada to Arco-U.S.Arco-U.S.has to pay a U.S.ad valorem tariff of 6%.Tax accountants advise Arco that it can set the transfer price in the range of $15-$18 per barrel of product.The current price is set at $16 a barrel.If Arco-Canada's tax rate is 50% the U.S.rate is 46%. ,what is the incremental cash flow per month associated with using the optimal transfer price?

Question

Quizplus · Accepted Answer

To find the optimal transfer price we need to compare the costs and benefits of setting the price at $15, $16, or $18 per barrel.

If Arco-Canada sets the transfer price at $15 per barrel, then the U.S. tariff will be applied to a lower base, resulting in lower taxes. However, Arco-Canada will also receive lower revenue per barrel. Therefore, the net effect on cash flows needs to be calculated.

If Arco-Canada sets the transfer price at $18 per barrel, then the U.S. tariff will be applied to a higher base, resulting in higher taxes. However, Arco-Canada will also receive higher revenue per barrel. Therefore, the net effect on cash flows needs to be calculated.

Using the given tax rates and transfer prices, we can calculate the net cash flow for each option:

Transfer price = $15 per barrel:
Revenue = 15 million barrels x $15 = $225 million
Cost of goods sold = $225 million x 50% = $112.5 million
U.S. ad valorem tariff = $225 million x 6% = $13.5 million
Net cash flow = $225 million - $112.5 million - $13.5 million = $99 million

Transfer price = $16 per barrel:
Revenue = 15 million barrels x $16 = $240 million
Cost of goods sold = $240 million x 50% = $120 million
U.S. ad valorem tariff = $240 million x 6% = $14.4 million
Net cash flow = $240 million - $120 million - $14.4 million = $105.6 million

Transfer price = $18 per barrel:
Revenue = 15 million barrels x $18 = $270 million
Cost of goods sold = $270 million x 50% = $135 million
U.S. ad valorem tariff = $270 million x 6% = $16.2 million
Net cash flow = $270 million - $135 million - $16.2 million = $118.8 million

As we can see, setting the transfer price at $16 per barrel leads to the highest net cash flow, with an incremental cash flow of $105.6 million - $99 million = $6.6 million per month. Multiplied by 12 months, the incremental cash flow per year is $79.2 million.

Arco Ships 15 Million Barrels of Refined Oil Monthly from Arco-Canada