Economics FE Practice Problems

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Economics FE Practice Problems

© All Rights Reserved

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Note: Corporate tax rates are used in problems.

12.1

A company wants to set up a new office in a country where corporate tax rate is as

follows: 15% of first $50,000 taxable income; 25% of next $25,000; 34% of next

$25,000; and 39% of everything over $100,000. Executives estimate that they will have

gross income of $500,000; total expenses of $300,000; $30,000 in allowable tax

reductions; and a onetime business start-up tax credit of $8,000.

a. Determine the taxable income for the first year.

b. How much should the company expect to pay in taxes?

Solution:

a) Taxable Income = Gross income all expenditures except capital expenditures

allowable deductions (depreciation and depletion charges)

= ($500,000 $300,000) $30,000

= $170,000

b) Income tax = 0.15 ($50,000) + 0.25 ($25,000) + 0.34 ($25,000) + 0.39 ($70,000)

tax credits

= $49,550 8,000

= $41,550

12.2

A corporation in an industrialized state has a state taxable income of $150,000. If the

state has a corporate tax rate of 9.6% of taxable income,

a. Determine the total state and federal tax that the corporate must pay

b. Compute its combined incremental state and federal income tax rate

Solution:

a) State Tax = 9.6% ($150,000) = $14,400

Federal Taxable Income = $150,000 $14,400 = $135,600

Federal Tax = $22,250 + 0.39 ($135,600 $100,000) = $36,134

Total State + Federal Tax = $50,534

b) Combined incremental state and federal income tax rate:

0.096 + 0.39 (1 0.096) = 0.4486 = 44.86%

12.3

A mining corporation purchased $120,000 of production machinery and depreciated it

using SOYD depreciation, a 5-year depreciation life, and zero salvage value. The

corporation is a profitable one that has a 34% combined incremental tax rate. At the end

of 5 years, the mining company changed its method of operation and sold the production

machinery for $40,000. During the 5 years the machinery was used, it reduced mine

operating costs by $32,000 a year, before taxes. If the company MARR is 12% after tax,

was the investment in the machinery a satisfactory one? (Use present worth or rate of

return analysis)

Solution:

SOYD Depreciation

SOYD = (N/2) (N + 1) = (5/2) 6 = 15

Year 1 Depreciation = (5/15) ($120,000 $0) = $40,000

Gradient = (1/15) ($120,000 $0) = $8,000

NPW (12%) = $34,720 (P/A, 12%, 4) $2,720 (P/G, 12%, 4) + $50,240 (P/F, 12%, 5)

$120,000

= $105,445 $11,255 + $28,506 $120,000 = +$2,726 > 0 (Calculator solution:

ROR = 12.88%)

Therefore, investment was satisfactory.

12.4

An automaker is buying some special tools for $100,000. The tools are being depreciated

by double declining balance depreciation using a 4-year depreciable life and a $6250

salvage value. It is expected that the tools will actually be kept in service for 6 years and

then sold for $6250. The before-tax benefit of owning the tools is as follows:

Year

1

2

3

4

5

6

Before-Tax Cash

Flow

$30,000

$30,000

$35,000

$40,000

$10,000

$10,000

$6250 Selling price

Compute the after-tax rate of return for this investment situation, assuming a 46%

incremental tax rate. If after tax MARR is 15%, was this a satisfactory investment?

Solution:

DDB depreciation, dt =

NPW=0 = -100,000+39,200(P/F,i%,1)+ 27,700(P/F,i%,2)+ 24,650(P/F,i%,3)+

24,475(P/F,i%,4)+ 5,400(P/F,i%,5)+ 11,650(P/F,i%,6)

Estimate starting point for ROR

Total return for 6 years = (Sum of the benefits Sum of the costs)/Sum of the costs

= (133,075 100,000)/100,000 = 0.33075

Average per year = 0.33075/6 = 0.055125 = 5.51%

Try 6%, NPW=13,965

Try 10%, NPW=3,694.69

Try12%, NPW=-851.68

Using linear interpolation, After-Tax Rate of Return, i = 11.6%, IRR < MARR = 15%,

thus it was not a satisfactory investment.

3

12.5

Mr. Jones, a successful businessman, is considering erecting a small building on a

commercial lot which he can buy for $30,000. A local company is willing to lease the

building for 5 years at $9000 per year, paid at the end of each year. Mr. Jones could have

the building constructed for $82,000.

Mr. Jones has an annual taxable income from other sources which results in a combined

incremental tax rate of 27%. He could depreciate the property by modified accelerated

cost recovery system (MACRS) with midmonth convention. He believes that at the end

of the 5-year lease he could easily sell the entire property (land and building) for

$125,000 (assume the land is not expected to appreciate in value). Current tax law sets

the capital gains tax rate at 20%. What is the after tax present worth of this 5-year venture

if Mr. Jones uses a 10% after-tax MARR? Assume that the building was placed in service

on January 1 and sold on December 31 after 5 years.

Solution:

The building is in the 39-year real property class. Land is a nondepreciable asset.

MACRS depreciation (building) schedule:

Year

1

2-4

5

Depreciation

2.461%(82,000)=2,018.02

2.564%(82,000)=2102.48

2.461%(82,000)=2018.02

Capital gain tax = 0.20*13,000 = $2600

Depreciation recapture = 2018.02*2 + 2102.48 *3 = $ 10,343.48

Depreciation recapture tax = 0.27 * 10,343.48 = $2,792.74

Total depreciation recapture and capital gain taxes= 2600+2792.74= $5,392.74

Year

BTCF

0

0

1

2

3

4

5

5

-82,000

-30,000

9,000

9,000

9,000

9,000

9,000

125,000

MACRS

Depreciation

Bld.

Land

2,018.02

2102.48

2102.48

2102.48

2018.02

Taxable

income

6981.98

6897.52

6897.52

6897.52

6981.98

23,427.94

Income

taxes

-1,885.13

-1,862.33

-1,862.33

-1,862.33

-1,885.13

-5,392.74

ATCF

-112,000

7,114.87

7,137.67

7,137.67

7,137.67

7114.87

119,607.26

7114.87(P/F,10%,5)+ 119,607.26 (P/F,10%, 5)

= -112,000 + 7114.87 (0.9091) + 7137.67 (2.487)(0.9091) + 7114.87 (0.6209)+

119,607.26 (0.6209)

= - $ 10,712.32, thus this project would not be an acceptable investment.

12.6

A sales engineer has the following alternatives to consider in touring his sales territory.

a) Buy a new car for $14,500. Salvage value is expected to be about $5,000 after 3

years. Maintenance and insurance cost is $1000 in the first year and increases at

the rate of $500/year in subsequent years. Daily operating expenses are $50/day

b) Rent a similar car for $80/day

Based on a 12% after-tax rate of return, how many days per year must he use the car to

justify its purchase? You may assume that this sales engineer is in the 30% corporate

incremental tax bracket. Use MACRS depreciation.

Solution:

Let X = number of days car used per year. Automobiles are in the MACRS 5-year

property class.

MV=$5000;

BV=14500-(2900+4640+1392) = $5,568

Capital loss on disposal = $568

NPW = $14,500 + $21X (P/A, 12%, 3) + $170 (P/F, 12%, 1) + $342 (P/F, 12%, 2)

+ $4,188 (P/F, 12%, 3) = 0

= $14,500 + $21X (2.402) + $170 (0.8929) + $342 (0.7972) + $4,188 (0.7118) = 0

X = 220 days

12.7

Two mutually exclusive alternatives are being considered by a profitable corporation

with an annual taxable income between $5million and $10 million

Year

0

1

2

3

4

5

Alt. A

-3000

1000

1000

1000

1000

1000

Alt. B

-5000

1000

1200

1400

2600

2800

Both alternatives have a 5-year useful and depreciable life and no salvage value.

Alternative A would be depreciated by sum-of-years-digits depreciation and alternative B

by straight-line depreciation. If the after tax MARR is 10%, which alternative should be

selected? (use IRR analysis)

Solution:

12.8

A profitable corporation with $7 million in annual taxable income is considering two

alternatives:

Year

0

1-10

11-20

Alt. 1

Alt. 2

-$10,000

-$20,000

4,500

4,500

0

4,500

depreciable life and no salvage value. Neither alternative is to be replaced at the end of its

useful life. If the corporation has an after tax MARR of 10%, which alternative should it

select?

Solve the problem by:

a) Present worth analysis

b) Annual cash flow analysis

c) Rate of return analysis

d) Future worth analysis

e) Benefit-cost ratio analysis (basic, conventional form)

Solution:

(a) To maximize NPW, choose Alternative 1 with a total present worth of $10,340.

(b) To maximize (EUAB EUAC), choose Alternative 1 with (EUAB EUAC) =

$1,215.

(c) Based on the rate of return of 9.2% from investing in Alt. 2 instead of 1, note that the

increment is unacceptable. Choose Alternative 1.

(d) To maximize Net Future Worth, choose Alternative 1 with a net future worth of

$69,566.

(e) Because the 2 1 increment has a B/C ratio =0.91, less than 1, reject the increment

and select Alternative 1.

Partial Answers

12.1 a) $170,000; b) $41,550

12.2 a) $50,534; b) 44.86%

12.3 NPW>0; (ROR = 12.88%).Therefore, investment was satisfactory.

12.4 i = 11.6%

12.5 -$10,712.32,

12.6 220 days

12.7 choose B

12.8

b) Select Alt. 1, EUAW (10%) = $1,215;

c) Select Alt. 1, IRR (2-1) = 9.2%

d) Select Alt. 1, FW (10%) = $69,566

e) Select Alt.1, B/C=0.91

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