The CFO of the ABC Corporation asks you to address the following three questions. ABC faces a top corporate marginal tax rate of 35% on both ordinary income and on capital gains.
a. The firm is considering investing in some equipment costing $ 500,000. A 10% investment tax credit is available on the equipment. The equipment is depreciable using straight line depreciation over 3 years with a zero salvage value. The firm uses an after tax discount rate for this type of investment of 10%. The CFO asks you to estimate the present value of the tax savings from this investment. Assume the tax credit and first year depreciation are taken immediately. How do the present value of the tax deductions compare with immediate expensing of the total outlay (with no investment tax credit)?
b. The equipment above is expected (assumed here for simplicity) to generate a one time pretax cash flow of approximately $ 805,255 at the end of year 5. The CFO asks you to estimate the expected annualized pretax and after tax rates of return on this investment. Would you recommend undertaking this investment? Is this a tax favored investment? Does it bear implicit taxes?
c. The firm has $ 5 million in short term investments. The money is to be used to expand facilities. However, due to regulatory delays in obtaining environmental approval, the expansion has been delayed 5 years. The firm now wishes to invest the funds in longer term higher yielding securities. The firm is considering three options:
i. Invest in corporate bonds yielding 12% per annum pretax.
ii. Invest in non dividend paying corporate equities, expected to earn 12% per annum pretax.
iii. Invest in preferred stock of other corporations paying a 10% dividend per year.
The corporation is eligible for a 70% dividends received deduction. Which option would you recommend and why? State any assumptions you need to make.
d. The CFO asks you to prepare a proposal outlining any tax arbitrage strategies that the firm might be able to undertake to reduce its taxes. In preparing your proposal, make sure that the strategies do not run afoul of the tax rule restrictions listed in this chapter. Provide a numerical example for each strategy to illustrate how it would work and how much in taxes it would save.