The effective combined tax rate in a firm is 40%. An outlay of $2 million for certain new assets is under consideration. Over the next 8 years, these assets will be responsible for annual receipts of $600,000 and annual disbursements (other than for income taxes) of $250,000. After this time, they will be used only for stand-by purposes with no future excess of receipts over disbursements a) What is the prospective rate of return before income taxes?

b) What is the prospective rate of return after taxes if straight-line depreciation can be used to write off these assets for tax purposes in 8 years?

c) What is the prospective rate of return after taxes if it is assumed that the assets must be written off for tax purposes over the next 20 years, using straight line depreciation?

a) The prospective rate of return before income taxes is 40%

b) The prospective rate of return after taxes if straight-line depreciation can be used to write off these assets for tax purposes in 8 years is 24%

c) The prospective rate of return after taxes if it is assumed that the assets must be written off for tax purposes over the next 20 years, using straight line depreciation 150%

Explanation:

a) What is the prospective rate of return before income taxes?

The annual profit from business only is $350,000 = annual receipts of $600,000 - annual disbursements of $250,000

Then total profit in 8 years is $2.8 million = $350,000 x 8 years

So profit from investment after 8 years (regardless net present value) is $800,000 = $2.8 million - outlay of $2 million

The prospective rate of return before income taxes is 40% = profit $800,0000 / investment of $2 million x 100%

b) What is the prospective rate of return after taxes if straight-line depreciation can be used to write off these assets for tax purposes in 8 years?

The depreciation booked in expenses annually in every 8 years is $250,000

The annual profit after tax annually is $60,000 = (annual profit from business of $350,000 - depreciation of $250,000) x (1-40%)

So the profit after tax and straight-line depreciation in 8 years is $480,000 = annual profit of $60,000 x 8 years

The prospective rate of return after taxes if straight-line depreciation can be used to write off these assets for tax purposes in 8 years is 24% = $480,000 / $2 million x 100%

c) What is the prospective rate of return after taxes if it is assumed that the assets must be written off for tax purposes over the next 20 years, using straight line depreciation?

The depreciation booked in expenses annually in every 20 years is $100,000

The annual profit after tax annually is $150,000 = (annual profit from business of $350,000 - depreciation of $100,000) x (1-40%)

So the profit after tax and straight-line depreciation in 20 years is $3 million = annual profit of $150,000 x 20 years

The prospective rate of return after taxes if it is assumed that the assets must be written off for tax purposes over the next 20 years, using straight line depreciation 150% = $3 million / $2 million x 100%