Question

Company P must choose between two alternate transactions. The cash generated by Transaction 1 is taxable and the cash generated by Transaction 2 is nontaxable. Determine the marginal tax rate at which the after-tax cash flows from the two transactions are equal assuming that:

a. Transaction 1 generates $100,000 of income and Transaction 2 generates $60,000 of income.

b. Transaction 1 generates $160,000 of income and Transaction 2 generates $120,000 of income.

Answer 1

A 40%

B 25%

Step-by-step explanation:

We need the tax rate which equal the cash flow of transaction 1 with transaction 2

That way, transaction 1 is the before tax

and transaction 2 is the after tax

transaction 1 X (1 - t) = Transaction 2

before tax X (1-t) = after tax

we clear for tax rate and reach this formula:

`(before \:tax - after \:tax )/(before \: tax) =$Tax Rate`

Now we post the values on the formula and solve for each alternative

A

`(100,000 - 60,000 )/(100,000) =$Tax Rate`

Tax rate = 40%

B

`(160,000 - 120,000 )/(160,000) =$Tax Rate`

Tax rate = 25%