E14-31 A comparison of Investment Alternatives including income taxes
Ms. Keri Lee, an expert in retro-fitting buildings to meet seismic safety standards, has just received a $200,000 after-tax bonus for the successful completion of a project on time and under budget. Business has been so good that she is planning to retire in 12 years, spending her time relaxing in the sun, skiing, and doing charitable work. Ms. Lee is considering 2 alternatives for investing her bonus.
Alternative 1: Municipal bonds can be purchased that mature in 12 years and that bear interest at 8%. This interest would be tax-free and paid semiannually.
Alternative 2: A small discount perfume shop is available for sale at a nearby factory outlet center. The business can be purchased from its current owner for $200,000. The following information relates to this alternative:
a. Of the purchase price, $80,000 would be for fixtures and other depreciable items. The remainder would be for the company's working capital (inventory, accounts receivable, and cash). The fixtures and other depreciable for tax reporting purposes are depreciated over 8 years using the following allowances published by the Internal Revenue Services:
Year % of original cost depreciated
Salvage value is not deducted when computing depreciation for tax purposes. At any rate, at the end of 12 years, these depreciable items would have a negligible salvage value; however, the working capital would be released for reinvestment elsewhere.
b. Store records indicate that sales have averaged $400,000 per year, and out-of-pocket costs have averaged $370,000 per year (not including income tax). These out-of-pocket include rent on building, cost of goods sold, utilities, and wage and salaries for the sales staff and the store manager. Ms. Lee plans to entrust the day-to-day operations of the store to the manager.
c. Ms. Lee's tax rate is 40%.
d. Ms. Lee wants an after-tax return on her investment of at least 8%.
Advise Ms. Lee as to which alternative should be selected. Use the total-cost approach to discount cash flow in your analysis. (round all dollar amounts to the nearest whole dollar.)
The solution presents full calculations of both alternatives and suggests the best answer.