chapter 3 tax
In computing net cash flows, the ______ associated with a deductible expenditure can be considered a ______.
tax savings, cash inflow
True or false: The ability to defer payment of a tax to a later time period increases the net present value of the after-tax cash flow of the transaction. However, this financial benefit may be mitigated if Congress increases tax rates over that same time period.
true Reason: In general, deferring the payment of tax increases the NPV of the transaction. However, this benefit may be offset by any tax increase that occurs during that same period.
You engage in a transaction that requires an initial investment of $10,000. You anticipate that you will realize a single positive after-tax cash flow of $12,000 five years from now related to the investment. Which answer best approximates the net present value of the transaction, assuming a 4% discount rate? (Refer to the attached Present Value Tables as needed.)
$(136) -- net cash outflow Reason: Using the PV of $1 Table -10,000 + (12,000 × 0.822) = -$136.
Which answer best approximates the present value of receiving $500 two years from today and $1,000 three years from today, assuming a 6% discount rate? (Refer to the attached Present Value Tables as needed.)
$1,285 Reason: Using the PV of $1 table (500 × 0.890) + (1000 × 0.840) = $1,285.
You have been guaranteed four annual payments of $10,000 to be received each year starting one year from today. Which answer best approximates the present value of this stream of payments, assuming a 6% discount rate? (Refer to the attached Present Value Tables as needed.)
$34,650 Reason: Using PV of Annuity Table 10,000 × 3.465 = $34,650.
Which answer best approximates the net present value of receiving $1,000 in two years and making a $500 payment three years from today, assuming a 5% discount rate? (Refer to the attached Present Value Tables as needed.)
$475 -- net cash inflow Reason: Using the PV of $1 Table (1,000 × 0.907)+ (-500 × 0.864) = $475.
Which answer best approximates the net present value of making a payment of $2,000 in one year and receiving $3,000 three years from today, assuming a 6% discount rate? (Refer to the attached Present Value Tables as needed.)
$634 -- net cash inflow Reason: Using the PV of $1 Table (-2,000 × 0.943)+ (3,000 × 0.840) = $634.
Which of the following statements regarding risk is false? (Select all that apply.)
-Assume two investments with identical cash flows, the riskier investment will have a higher NPV. Reason: The riskier investment will have a higher discount rate and lower NPV. -Risk is constant. It does not change over time or across transactions. Reason: Risk is not constant over time or across transactions.
Which of the following statements are true? (Select all that apply.)
-The first step in evaluating business transactions is quantifying the cash flows associated with the transaction. -Costs are an essential component of the business activity and contribute to profitability of the firm.
A private letter ruling is ______. (Select all that apply.)
-an agreement that the IRS will not challenge the taxpayer if the tax consequences of the transaction are reported as identified in the PLR -often requested by a taxpayer to reduce audit risk
Amy purchased property for $100,000. Five years later she sold the property for $150,000. The gain on the sale of this property is taxable income that is taxed at a 20% marginal tax rate. The sales transaction resulted in a tax cost of $ and generated after-tax net cashflow of $.
Blank 1: 10,000 or 10000 Blank 2: 140,000 or 140000
Which of the following statements about marginal tax rates is false?
As the marginal tax rate increases, the tax cost of an income generating transaction decreases.
Which of the following statements most accurately describes audit risk?
Audit risk reflects the risk that the IRS may interpret or apply the law to a transaction differently than the position taken by the taxpayer.
Fan Club Inc. sold 100 t-shirts for $15 each at an event. The t-shirts were purchased in the same year for $10 each. Fan Club is subject to a 20% marginal tax rate. The tax cost associated with the sales is $ and the transactions generated a total positive after-tax net cash flow of $ after considering both the purchase of inventory and the subsequent sale.
Blank 1: 100 Blank 2: 400
Wylie Inc. is subject to a 30% marginal tax rate. Wylie paid employees wages amounting to $100,000. As an ordinary and necessary business expenditure, the cost associated with employee wages is deductible. The tax savings associated with that expenditure is $and the after-tax cash outflow is $.
Blank 1: 30,000 or 30000 Blank 2: 70,000 or 70000
Assume Snow Corporation is subject to a 20% marginal tax rate. Snow Corporation made a $20,000 deductible cash expenditure. The tax savings associated with that expenditure is $ and the after-tax cash outflow is $.
Blank 1: 4,000 or 4000 Blank 2: 16,000 or 16000
A(n) transaction is one in which it is presumed each party is negotiating in its own economic self-interest. (enter one word per blank)
Blank 1: arms or arm's Blank 2: length
Which of the following situations is least likely to result in increased marginal tax rate uncertainty for the taxpayer?
Due to a natural disaster, Congress extended the filing deadline for all taxpayers in the affected area.
Atlas Corp. engaged in a transaction in the current year that generated $20,000 cash inflow. Which of the following statements is false?
If the cash inflow is taxable income and Atlas is subject to a 10% tax rate, the after-tax cash inflow is $2,000. Reason: Tax is computed as $20,000 × 10% = $2,000. After-tax cash flow is $20,000 - 2,000 = $18,000. Reason: $20,000 × 25% = $5,000.
Seattle Services engaged in a current year transaction that required a $30,000 cash outflow. Which of the following statements is true? (Select all that apply.)
If the cash outflow is fully deductible and Seattle's marginal tax rate is 10%, the after-tax net cash outflow is $27,000. Reason: - $30,000 cash outflow + $3,000 cash inflow from tax savings = - $27,000 net cash outflow. -If the cash outflow is fully deductible and Seattle's marginal tax rate is 20%, the tax savings from the transaction is $6,000. Reason: $30,000 × 20% = $6,000.
Katie has started a new business and has been advised that she should not hire an employee but rather, should engage an independent contractor to perform the services that she needs. By doing so, she will minimize her payroll taxes. Which of the following statements is false?
Katie should evaluate the net present value of the before tax cash flow to determine her best option. Reason: Katie should evaluate the NPV of AFTER tax cash flow to determine her best option.
Which of the following are examples of transactional markets? (Select all that apply.)
Related party Public Private
Match the transaction with the transactional market or type of transaction it best illustrates.
Related party- Little Corp. is a subsidiary of Big Inc. Little leases heavy machinery to Big. Private market-James is negotiating a compensation contract with his employer. James is not a shareholder or owner of the company. Public market-Choice, Mrs. Phelps purchased 1000 shares of Google stock through her broker. Mrs. Phelps purchased 1000 shares of Google stock through her broker. Arm's length-Choice, National Corp. has contracted with TechWiz to supply their technology needs. The companies have no common owners. National Corp. has contracted with TechWiz to supply their technology needs. The companies have no common owners.
Riley received a $90,000 cash payment of which $40,000 was exempt from taxation. Riley's marginal tax rate is 30% and she has a 20% average tax rate. Which of the following statements is true?
Riley's tax cost is $15,000 and her after-tax cash flow is $75,000. Reason: Tax Cost: $50,000 taxable × 30% = $15,000 Note: Always use the marginal tax rate to evaluate. After-tax cash flow: $90,000 received - 15,000 tax = $75,000
Match the form of uncertainty or risk with the best description.
Tax law uncertainty- Reflects the likelihood that tax law may change relative to what the taxpayer anticipated Audit risk- Reflects the possibility that the IRS may interpret or apply the law differently than the taxpayer Marginal tax rate uncertainty- Reflects the possibility that a change to the taxpayer's financial situation may result in unanticipated changes to the marginal tax rate
Which of the following statements best describes "tax minimization"?
Tax minimization with respect to a transaction may not always be the optimal strategy.
Which of the following statements is false?
Tax rates are constant across time and across transactions. Reason: Tax rates can change across time and can vary across different types of transactions.
Which of the following statements about a related party transaction is false?
The IRS may disallow favorable tax outcomes if it is determined the parties transacted at arm's length.
Jeremiah has been given the option to receive $2,000 in two years or $2,400 in four years. Which of the following statements is true?
The NPV of each option is dependent on the assumed discount rate and the length of the deferral period.
Acme Corporation engaged in a transaction that required a $20,000 expenditure. The expenditure was 50% deductible and Acme is subject to a 20% marginal tax rate. Which of the following statements are true? (Select all that apply.)
The after-tax cash outflow associated with the expenditure is $18,000. Reason: - $20,000 before tax cash outflow + $2,000 tax savings = - $18,000 net cash outflow. The tax savings associated with the expenditure is $2,000. Reason: $10,000 is deductible × 20% tax rate = $2,000 tax savings.
Which of the following statements best describes the estimation of a discount rate for analyzing a transaction?
The higher the risk involved in a transaction, the higher the discount rate.
Which statement is false regarding transactional markets?
The type of transactional market (public, private, etc.) has little impact on the degree of control a manager has to structure a transaction.
Ms. Bowles is retiring this year. She has arranged to received $3,000 each month from her retirement account for the next five years. Which of the following statements regarding her retirement arrangement is false?
This stream of payments cannot be evaluated as an annuity because they are received monthly rather than annually.
Which of the following statements reflect the primary source of marginal tax rate uncertainty? (Select two answers.)
Unanticipated changes to the tax rate structure Unanticipated changes to a taxpayer's taxable income
Which of the following statements about private market transactions is true?
Unlike public markets, transacting parties have the opportunity for bilateral tax planning.
Which of the following is not descriptive of the method for evaluating an annuity using present value tables?
Variability in the assumed discount rate Reason: When evaluating an annuity using present value tables, the discount period is assumed to be consistent over the annuity period.
A(n) is a series of equal payments to be received at the end of consecutive periods for a specific length of time.
annuity
The arm's-length transaction presumption ______.
assumes each party is dealing in its own economic self-interest
Rally Corporation has been advised by its accountant to deduct an expenditure that the IRS has disallowed for other corporations in similar circumstances. If Rally decides not to take the deduction, Rally is most directly minimizing ______.
audit risk
True or false: A transaction that reduces the tax cost always increases the NPV of the transaction.
false Reason: If the strategy increases a non-tax cost more than it reduces the tax cost, it will decrease the NPV.
True or false: Time value refers to the fact that a dollar available today is worth less than a dollar available in the future.
false Reason: Time value refers to the fact that a dollar available today is worth more than a dollar available in the future.
As the marginal tax rate increases, the tax savings associated with an expenditure ______ and the after-tax cost of the expenditure ______.
increases, decreases
Tax savings associated with a deductible expenditure are a function of the deductible amount and the tax rate.
marginal
In public market transactions, the parties ______.
must engage in unilateral, rather than bilateral, tax planning
is the difference between the cash received and the cash disbursed in a transaction. (Enter one word per blank)
net cash flow
When the IRS audits a tax return, it is most likely to scrutinize the tax consequences of a(n) ______.
related party transaction
In December 2014, Congress passed legislation that was retroactively applied to the entire year. This legislation increased ______.
tax law uncertainty
Under the Bush administration, Congress passed a series of temporary tax cuts. If not made permanent before expiration in 2011, the law would revert back to its "pre-Bush" form. The temporary nature of this tax legislation increased ______.
tax law uncertainty