- This topic has 9 replies, 3 voices, and was last updated 6 years ago by
.
- Posts
Please help me with the following question, i do not understand BPP’s answer at the back.
Juicy Co is considering investing in a new industrial juicer for use on a new contract. It will cost $150 000 and will last 2 years. Juicy Co pays corporation tax at 30% ( as the cash flows occur) and, due to health benefits of juicing, the machine attracts 100% tax allowable depreciation immediately.
Given a cost of capital of 10%, what is the minimum value of the pre tax contract revenue receivable in 2 years which would be required to cover the net cost of the juicer?
A: $150 0000
B: $105 000
C: $127 050
D: $181 500Thank you so much.
The flows (ignoring the revenue) are as follows:
0 Cost (150,000)
0 Tax saving on depreciation (150,000 x 0.3) 45,000So a PV of (105,000)
If the revenue is R, then the after tax flow in 2 years time is R – 0.3R = 0.7R
For break even, then NPV needs to be zero, and therefore the PV of 0.7R has to equal 105.000
So 0.7R x 0.826 = 105,000
R = 181,598, and so the answer has to be D(The reason that it is a bit different to 181,500 is due to rounding – the exact discount factor of 2 years at 10% – 1/(1.1)^2 and if you do it to more decimal places then it does come to 181,500)
“If the revenue is R, then the after tax flow in 2 years time is R – 0.3R = 0.7R”
Why is this? Im not getting it? You’ve already worked out the tax….
But there are two tax effects – the tax saving on the tax allowable depreciation but also the tax that have to be paid on the revenue.
If the revenue is R, then they will have to pay tax of 0.3R on it, leaving a net inflow of 0.7R
Hi John… i have a quick question. The question above says “what is the minimum value of the pre tax contract revenue ” required. I believe pre tax means before tax effect..So shouldnt R be not after deducting tax?
Please help me on this?
Pre-tax does indeed mean before tax.
But the tax is affected by the revenue and in what I wrote above R is pre-tax.
- The topic ‘BPP Question on investment appraisal:’ is closed to new replies.