Welcome to question #4 of our series of Practice Problems. These Practice Problems will put to use the skills and concepts taught in our BizBasics Online courses and will reinforce your learning. If you start quaking in your boots when you read some of these terms (i.e. NPV, IRR, PI, et. al.), then make sure you check out our Finance courses and other BBO courses to learn all about what they mean and how to apply them.
If you would like to submit a problem that we can use for our Practice Problem series, email us at comments@BizBasicsOnline.com.
For this Practice Problem, you may want to download or pull up the workbook before you start the problem. It has 2 spreadsheets in it: one spreadsheet has some blank cells, the other spreadsheet has the completed cells for you to compare your answers.
Enough of the chit-chat. Let’s get on with our story…
It’s the Asphalt!
Bill and Lola are entrepreneurs and small business people.
They have operated a successful sub-contracting business. They are experts in asphalt laying. Bill is the operator and Lola does the books. If something goes wrong, they often say, “It’s not Bill’s fault. It’s not Lola’s fault. It’s the asphalt!” (They got a kick out of the play on words. Get it? Ass fault.)
Bill and Lola plan to retire in five years. With the prospects of construction picking up in their area, they are considering buying a new asphalt-laying machine and improving their income as they stretch for retirement years. Is it a good investment?
• The cost of the new machine is $1 million.
• The forecasted annual increase in revenue is $850K.
• The annual increase in all types of costs is $610K.
• The MACRS depreciation schedule is seven years.
• Assume the business has the cash to pay for the new machine…total equity financing (no loan).
• They assume they will sell the machine in five years for $900K.
• To make the investment work, their financial advisor promotes using the Internal Rate of Return method. The proposed IRR hurdle rate is 20%. This is the same as the discount rate and is high to reflect the riskiness of the investment.
Internal Rate of Return (IRR) is the discount rate at which the initial investment is equal to the present value of the future cash flows. To make a decision, Bill and Lola must establish their IRR “hurdle rate”. This is a rate that reflects the sizable risk of the investment.
Background on Taxes
Currently, the federal income tax rate on large businesses is 35% (at the time of the initial publishing of this practice problem*). We will use this even though Bill and Lola’s business is a small business to make the point about the overall economy. The spreadsheet adds another 5% for state income tax. So the effective rate is 40% currently. This is often characterized as the highest corporate tax rate in the world. Japan recently reduced their rate. They previously were the highest. Countries with the lowest corporate rate typically have the highest increase in GDP and per capita standard of living. Sweden is moving to 22%. One US political party is promoting 25% for America. The capital gains rate is also correlated with the economy.
A recent editorial in the Wall Street Journal shows how it has gone up and down over the past thirty years…with corresponding effects on the economy. We are currently at 15% capital gains. One party is discussing making it as high as 40%.
Given the political possibilities, use three scenarios in the spreadsheet by tweaking Cell E8 and E9:
1. Keep the current Income tax rate at 40% and the current capital gains rate at 15%.
2. Increase the capital gains rate to 40%.
3. Reduce the income tax rate to 30% while moving the capital gains back to 15%.
4. A fourth scenario, with high capital gains and low income tax rates, is logically possible, but not politically realistic.
Bill and Lola will await the election. If the party that is advocating lower income and capital gains is elected, perhaps they will move forward. The two scenarios with low capital gains tax meet their IRR hurdle rate. Otherwise, the Internal Rate of Return is not conducive to this investment. This fictitious account is typical of the uncertainty that is stalling our economy.
The answer spreadsheet has two worksheets: a completed sheet and one with a few blank cells. You can read this problem and in fifteen minutes (with the “solution” spreadsheet) review some important principles of accounting, NPV, PI, IRR and understand the effect of taxes on business decisions.
*This Practice Problem was originally published in Volume 9, Issue 4 of the BizBucks Quarterly newsletter.