Now suppose we impose a 20% tax on earnings minus labor costs (as discussed in class). In addition, the government introduces tax incentives for investment that reduce the effective depreciation rate to 3%. The dividend cost remains 5%. Now how many machines should the firm purchase? You must show your work for credit.?

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Explanation:

Given information:

>Suppose the new machinery cost $504

> Marginal benefit of new machine = 246 - 6 K

> k is the number of machine purchase

> depreciation rate = 12%

> dividend yield = 6%

> corporate tax = 35%

To provide the marginal cost of each dollar in the following situation

a) Firm allowed expenses with no tax credit

To find the optimal investment

Marginal Benefit = Marginal cost

in the given case the marginal cost of investment is sum of depreciation and dividends

ie., 0.12+0.6 = 0.18

setting that marginal cost equal to marginal benefit of 246-6K and for solving for K yields

ie.,0.18=246-6K

> 6K=246-0.18

> K = (246-0.18) / 6

>K = 40.97 units of machines purchased

when firm can expense (take full depreciation immediately) the cost of investment is reduced by 35% of tax ie., 35 cents per each dollar spent

Therefore., The marginal cost of the investment = (246 - (6*40.97)) (1-0.35)

= (246-245.82) (0.65)

= 0.117 per dollar

b) Investment tax credit of 8%

An investment tax credit reduces the cost of investment even further. if the investment tax credit were included in the tax system described in question a, the net cost of the firm would be

(Depreciation + Dividend) (1-0.35 - the ITC)

= (0.12+0.06) (0.65-0.08)

= (0.18) (0.57)

=0.1026 per dollar