Understal Company has $750,000 to invest and two competing investment opportunities. Investment 1 would pay 9% per year ($67,500 annual before-tax cash flow). Investment 2 would pay 7% per year ($52,500 annual before-tax cash flow). The return on Investment 1 is taxable at Understal's 35% rate on ordinary income, while the return on Investment 2 is taxable at a 20% preferential rate.A. Compute the explicit and implicit tax that Understal would pay with respect to each investment. B. Which investment results in the greater after-tax cash flow?
What will be an ideal response?
A. Understal would pay $23,625 explicit tax ($67,500 × 35%) and no implicit tax on Investment 1. It would pay $10,500 explicit tax ($52,500 × 20%) and $15,000 implicit tax (reduction in before-tax yield) on Investment 2.
B. Investment 1 results in $43,875 after-tax cash flow, while Investment 2 results in $42,000 after-tax cash flow.
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