Question

Isabel, a calendar-year taxpayer, uses the cash method of accounting for her sole proprietorship. In late December she received a $20,000 bill from her accountant for consulting services related to her small business. Isabel can pay the $20,000 bill anytime before January 30 of next year without penalty. Assume her marginal tax rate is 37 percent this year and next year, and that she can earn an after-tax rate of return of 12 percent on her investments. a. What is the after-tax cost if Isabel pays the $20,000 bill in December? b. What is the after-tax cost if Isabel pays the $20,000 bill in January? Use Exhibit 3.1. (Round your answer to the nearest whole dollar amount.) c. Based on requirements a and b, should Isabel pay the $20,000 bill in December or January? multiple choice December January

Answer 1

A. $12,600

B. $13,392

C. Isabel should pay the $20,000 bill in December

Step-by-step explanation:

A. Calculation for the after-tax cost if Isabel pays the $20,000 bill in December

First step is to calculate present value tax savings

Present value tax savings=$20,000 x 37%

Present value tax savings= $7,400

Now let calculate the After-tax cost

After-tax cost = $20,000 - $7,400

After-tax cost = $12,600

Therefore the after-tax cost if Isabel pays the $20,000 bill in December is $12,600

B. Calculation for the What the after-tax cost if Isabel pays the $20,000 bill in January

First step is to calculate present value tax savings

Present value tax savings=($20,000 x 37%)* (Discount factor, 1 year, 12%)

Present value tax savings= $7,400 * .893

Present value tax savings=$6,608

Now let calculate the After-tax cost

After-tax cost= $20,000 - $6,608

After-tax cost = $13,392

Therefore the after-tax cost if Isabel pays the $20,000 bill in January is $13,392

c. Based on the above calculation for a and b Isabel should pay the $20,000 bill in the month of December reason been that in a situation where her payment is increase from the month of January to the month of December it will tend to lead to increase in the cash flow present value (PV) .