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Maximizing After-Tax Cash Flows From An Investment

Please show all calculations.

Gregly Company, which has a 33% marginal tax rate, plans to make an investment that should generate $300,000 annual cash flow/ordinary income.

Instead of making the investment directly, Gregly could form a new taxable entity (L'il Greg) to make the investment. L'il Greg's marginal tax rate on the investment income would be only 25%. However, L'il Greg would have to incur a $26,500 annual nondeductible expense associated with the investment that Gregly would not incur.

a. Should Gregly make the investment directly or make it through L'il Greg to maximize after-tax cash flow?

b. Would your answer change if L'il Greg could deduct its $26,500 additional expense?

Solution Preview

a. If Gregly Company makes the investment directly, it will owe $300,000*.33, or $99,000 per year in income taxes. Thus, its after-tax return will be $300,000-$99,000, or $201,000 per year. If L'il Greg makes the investment, it will owe $300,000*.25, or $75,000 per year in income taxes. Its after-tax return will be $300,000-$75,000, or $225,000. However, L'il Greg will pay $26,500 per ...

Solution Summary

The solution discusses if the company should make the investment directly or make it through a new taxable entity to maximize after-tax cash flow.

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