[kb24]

The following question is a CMA adapted question from Wiley, and I don’t understand the answer. Anyone out there have any ideas?

Andrew Corp is evaluating a capital investment that would result in a $30K higher contribution margin benefit and increased annual personnel costs of $20K. The effects of income taxes on the NPV computation on these benefits and costs for the project are to:

a. Decrease both benefits and costs

b. Have no net effect on either benefits or costs

c. Decrease benefits but increase costs

d. Increase benefits but decrease costs

According to Wiley the correct answer is (a) because income taxes decrease both revenues and costs in projecting future cash flows.

Any help would be appreciated. Thanks.

FAR 4/1/11 - 89
AUD 4/15/11 - 85
REG 4/29/11 - 80
BEC 5/13/11 - 85

[Taxi Cow Tent]

Hey KB-

Look at them individually and plug them into sample data.

I assume you see why the benefits are reduced by income taxes (ie, you earn 30k more but you have to pay tax so you only net, say $27k). So, your net inflow is really only $20k even though CM increased by $30k, so income taxes decrease the benefit.

The costs are are littler trickier to get your mind around, at least for me. I hope I don't have this right for the wrong reason but here goes:

Pre-investment Post-investment

Revenue 100 100

Costs (20) (40)

Income 80 60 (at this point, there is not effect of income taxes on the addt'l $20 of exp

Tax (10%) (8) (6)

Post Tax 72 54 (the increase in cost only results in $18 less of post-tax inc, so taxes have decreased the effect of the addt'l costs) – your inflow is not reduced by $20 but rather by 18.

Good luck!

FAR - 11/10 - 84
REG - 2/11 - 89
BEC - 5/11 - 80
AUD - 5/11 - 83

[kb24]

Thanks for your response, taxi cow tent. I'm still not sure I understand exactly what you're saying about the costs, but your answer got me thinking about the question in a different way so it now makes sense to me.

NPV of the project before taxes = 30K contribution benefit – 20K personnel costs.

NPV of project after taxes = (30K-20K)(1-tax rate) = 30K(1-tax rate) – 20K (1-tax rate)

So both the benefit and costs are reduced by the tax rate percentage. Thanks for your help.

FAR 4/1/11 - 89
AUD 4/15/11 - 85
REG 4/29/11 - 80
BEC 5/13/11 - 85

[Author]

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