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IE 3301 ENGINEERING ECONOMIC ANALYSIS

Ch12 Problems - Solutions


Note: Corporate tax rates are used in problems.
12.1
A company wants to set up a new office in a country where corporate tax rate is as
follows: 15% of first $50,000 taxable income; 25% of next $25,000; 34% of next
$25,000; and 39% of everything over $100,000. Executives estimate that they will have
gross income of $500,000; total expenses of $300,000; $30,000 in allowable tax
reductions; and a onetime business start-up tax credit of $8,000.
a. Determine the taxable income for the first year.
b. How much should the company expect to pay in taxes?
Solution:
a) Taxable Income = Gross income all expenditures except capital expenditures
allowable deductions (depreciation and depletion charges)
= ($500,000 $300,000) $30,000
= $170,000
b) Income tax = 0.15 ($50,000) + 0.25 ($25,000) + 0.34 ($25,000) + 0.39 ($70,000)
tax credits
= $49,550 8,000
= $41,550

12.2
A corporation in an industrialized state has a state taxable income of $150,000. If the
state has a corporate tax rate of 9.6% of taxable income,
a. Determine the total state and federal tax that the corporate must pay
b. Compute its combined incremental state and federal income tax rate
Solution:
a) State Tax = 9.6% ($150,000) = $14,400
Federal Taxable Income = $150,000 $14,400 = $135,600
Federal Tax = $22,250 + 0.39 ($135,600 $100,000) = $36,134
Total State + Federal Tax = $50,534
b) Combined incremental state and federal income tax rate:
0.096 + 0.39 (1 0.096) = 0.4486 = 44.86%

12.3
A mining corporation purchased $120,000 of production machinery and depreciated it
using SOYD depreciation, a 5-year depreciation life, and zero salvage value. The
corporation is a profitable one that has a 34% combined incremental tax rate. At the end
of 5 years, the mining company changed its method of operation and sold the production
machinery for $40,000. During the 5 years the machinery was used, it reduced mine
operating costs by $32,000 a year, before taxes. If the company MARR is 12% after tax,
was the investment in the machinery a satisfactory one? (Use present worth or rate of
return analysis)
Solution:
SOYD Depreciation
SOYD = (N/2) (N + 1) = (5/2) 6 = 15
Year 1 Depreciation = (5/15) ($120,000 $0) = $40,000
Gradient = (1/15) ($120,000 $0) = $8,000

NPW (12%) = $34,720 (P/A, 12%, 4) $2,720 (P/G, 12%, 4) + $50,240 (P/F, 12%, 5)
$120,000
= $105,445 $11,255 + $28,506 $120,000 = +$2,726 > 0 (Calculator solution:
ROR = 12.88%)
Therefore, investment was satisfactory.

12.4
An automaker is buying some special tools for $100,000. The tools are being depreciated
by double declining balance depreciation using a 4-year depreciable life and a $6250
salvage value. It is expected that the tools will actually be kept in service for 6 years and
then sold for $6250. The before-tax benefit of owning the tools is as follows:
Year
1
2
3
4
5
6

Before-Tax Cash
Flow
$30,000
$30,000
$35,000
$40,000
$10,000
$10,000
$6250 Selling price

Compute the after-tax rate of return for this investment situation, assuming a 46%
incremental tax rate. If after tax MARR is 15%, was this a satisfactory investment?
Solution:

DDB depreciation, dt =
NPW=0 = -100,000+39,200(P/F,i%,1)+ 27,700(P/F,i%,2)+ 24,650(P/F,i%,3)+
24,475(P/F,i%,4)+ 5,400(P/F,i%,5)+ 11,650(P/F,i%,6)
Estimate starting point for ROR
Total return for 6 years = (Sum of the benefits Sum of the costs)/Sum of the costs
= (133,075 100,000)/100,000 = 0.33075
Average per year = 0.33075/6 = 0.055125 = 5.51%
Try 6%, NPW=13,965
Try 10%, NPW=3,694.69
Try12%, NPW=-851.68
Using linear interpolation, After-Tax Rate of Return, i = 11.6%, IRR < MARR = 15%,
thus it was not a satisfactory investment.
3

12.5
Mr. Jones, a successful businessman, is considering erecting a small building on a
commercial lot which he can buy for $30,000. A local company is willing to lease the
building for 5 years at $9000 per year, paid at the end of each year. Mr. Jones could have
the building constructed for $82,000.
Mr. Jones has an annual taxable income from other sources which results in a combined
incremental tax rate of 27%. He could depreciate the property by modified accelerated
cost recovery system (MACRS) with midmonth convention. He believes that at the end
of the 5-year lease he could easily sell the entire property (land and building) for
$125,000 (assume the land is not expected to appreciate in value). Current tax law sets
the capital gains tax rate at 20%. What is the after tax present worth of this 5-year venture
if Mr. Jones uses a 10% after-tax MARR? Assume that the building was placed in service
on January 1 and sold on December 31 after 5 years.
Solution:
The building is in the 39-year real property class. Land is a nondepreciable asset.
MACRS depreciation (building) schedule:
Year
1
2-4
5

Depreciation
2.461%(82,000)=2,018.02
2.564%(82,000)=2102.48
2.461%(82,000)=2018.02

Capital gain = $125,000-(82,000+30,000) = $13,000


Capital gain tax = 0.20*13,000 = $2600
Depreciation recapture = 2018.02*2 + 2102.48 *3 = $ 10,343.48
Depreciation recapture tax = 0.27 * 10,343.48 = $2,792.74
Total depreciation recapture and capital gain taxes= 2600+2792.74= $5,392.74
Year

BTCF

0
0
1
2
3
4
5
5

-82,000
-30,000
9,000
9,000
9,000
9,000
9,000
125,000

MACRS
Depreciation
Bld.
Land
2,018.02
2102.48
2102.48
2102.48
2018.02

Taxable
income

6981.98
6897.52
6897.52
6897.52
6981.98
23,427.94

Income
taxes

-1,885.13
-1,862.33
-1,862.33
-1,862.33
-1,885.13
-5,392.74

ATCF

-112,000
7,114.87
7,137.67
7,137.67
7,137.67
7114.87
119,607.26

NPW(10%)= -112,000 + 7114.87 (P/F,10%,1) + 7137.67 (P/A,10%, 3)(P/F, 10%, 1) +


7114.87(P/F,10%,5)+ 119,607.26 (P/F,10%, 5)
= -112,000 + 7114.87 (0.9091) + 7137.67 (2.487)(0.9091) + 7114.87 (0.6209)+
119,607.26 (0.6209)
= - $ 10,712.32, thus this project would not be an acceptable investment.

12.6
A sales engineer has the following alternatives to consider in touring his sales territory.
a) Buy a new car for $14,500. Salvage value is expected to be about $5,000 after 3
years. Maintenance and insurance cost is $1000 in the first year and increases at
the rate of $500/year in subsequent years. Daily operating expenses are $50/day
b) Rent a similar car for $80/day
Based on a 12% after-tax rate of return, how many days per year must he use the car to
justify its purchase? You may assume that this sales engineer is in the 30% corporate
incremental tax bracket. Use MACRS depreciation.

Solution:
Let X = number of days car used per year. Automobiles are in the MACRS 5-year
property class.

MV=$5000;
BV=14500-(2900+4640+1392) = $5,568
Capital loss on disposal = $568
NPW = $14,500 + $21X (P/A, 12%, 3) + $170 (P/F, 12%, 1) + $342 (P/F, 12%, 2)
+ $4,188 (P/F, 12%, 3) = 0
= $14,500 + $21X (2.402) + $170 (0.8929) + $342 (0.7972) + $4,188 (0.7118) = 0
X = 220 days

12.7
Two mutually exclusive alternatives are being considered by a profitable corporation
with an annual taxable income between $5million and $10 million
Year
0
1
2
3
4
5

Alt. A
-3000
1000
1000
1000
1000
1000

Before-Tax cash flow


Alt. B
-5000
1000
1200
1400
2600
2800

Both alternatives have a 5-year useful and depreciable life and no salvage value.
Alternative A would be depreciated by sum-of-years-digits depreciation and alternative B
by straight-line depreciation. If the after tax MARR is 10%, which alternative should be
selected? (use IRR analysis)
Solution:

12.8
A profitable corporation with $7 million in annual taxable income is considering two
alternatives:
Year
0
1-10
11-20

Before-Tax cash flow


Alt. 1
Alt. 2
-$10,000
-$20,000
4,500
4,500
0
4,500

Both alternatives will be depreciated by straight-line depreciation assuming a 10-year


depreciable life and no salvage value. Neither alternative is to be replaced at the end of its
useful life. If the corporation has an after tax MARR of 10%, which alternative should it
select?
Solve the problem by:
a) Present worth analysis
b) Annual cash flow analysis
c) Rate of return analysis
d) Future worth analysis
e) Benefit-cost ratio analysis (basic, conventional form)
Solution:

(a) To maximize NPW, choose Alternative 1 with a total present worth of $10,340.
(b) To maximize (EUAB EUAC), choose Alternative 1 with (EUAB EUAC) =
$1,215.
(c) Based on the rate of return of 9.2% from investing in Alt. 2 instead of 1, note that the
increment is unacceptable. Choose Alternative 1.
(d) To maximize Net Future Worth, choose Alternative 1 with a net future worth of
$69,566.
(e) Because the 2 1 increment has a B/C ratio =0.91, less than 1, reject the increment
and select Alternative 1.

Partial Answers
12.1 a) $170,000; b) $41,550
12.2 a) $50,534; b) 44.86%
12.3 NPW>0; (ROR = 12.88%).Therefore, investment was satisfactory.
12.4 i = 11.6%
12.5 -$10,712.32,
12.6 220 days
12.7 choose B
12.8

a) Select Alt. 1, PW (10%) = $10,340;


b) Select Alt. 1, EUAW (10%) = $1,215;
c) Select Alt. 1, IRR (2-1) = 9.2%
d) Select Alt. 1, FW (10%) = $69,566
e) Select Alt.1, B/C=0.91