We are back with our Practice Problem series. We have pulled this NPV problem from the Biz Bucks Guy’s archives. Once you have created your own spreadsheet to get your conclusions, you can compare your answers to the Biz Bucks Guy’s answers HERE.
Reminder: These practice problems are intended for review of the skills and concepts taught in the BizBasics Online courses. If you are not familiar with the skills and concepts discussed in this practice problem, you can brush up by taking a BizBasics Online course.
Now…On with the show!
A few years ago, The Biz Bucks Guy heard that the famous golfer, Phil Mickelson, was contemplating moving from California to another state…solely because of the high taxes in California. Tiger Woods was interviewed a few minutes after the story about Mickelson broke and Tiger admitted he left California in 1997 for the same reason and moved to Florida.
The boo-birds have made a big squawk and demanded Mickelson stay in California and pay his “fair share”. This whole episode was sad. Of course, people need to do what is in their own best interest.
Not only rich golfers, but everyday businesses make decisions based on taxation.
The following practice problem is an example. The solution spreadsheet is available for you to tweak and see how taxes can affect decision making. As discussed in the final paragraphs below, this is also about static vs. dynamic scoring.
Static scoring means increased taxes provides a linear increase in revenues for the government. Dynamic scoring means tax policy changes behavior in the economy. Higher taxes lower GDP growth. Lowering taxes increases GDP growth. The Biz Bucks Guy agrees with those that encourage dynamic scoring of tax policy changes. This is a rough example of that principle.
Ok. Now that that is said, we can really be on with the show! (or Practice Problem in our case)
AJ’s Map company has finally decided to improve their marketing. They are contemplating investing in a new digital sign in front of their store that can be seen from a nearby freeway. The problem is AJ is watching the news and knows there is much uncertainty surrounding taxation. When he runs his NPV calculation, he does not know what to do about taxes, both income taxes and the capital gains tax.
The solution spreadsheet is based on the following information:
Assume the sign will last ten years before some new technology makes it obsolete.
Also, assume the Depreciation will be for seven years. Use straight-line depreciation.
Price of the new sign: $60,000
Sale of the sign in ten years: $48,000
Current annual revenue for AJ: $500,000
Increased annual revenue for AJ IF static scoring: 10%
Increased annual revenue for AJ IF dynamic scoring is used because of lowering taxes: 20%.
That’s right! In this fictional example, AJ is thinking Washington will lower taxes back from the new tax level passed to avoid the fiscal cliff. The discount rate is 18% for AJ’s level of risk.
Inflation is assumed to be 3%. The new tax rate (fed and state) is 47% with capital gains at 23.8% which includes the 3.8% for ObamaCare. If taxes were lowered (this guy AJ is a true optimist), the assumed lowered taxes would be 40% with Capital Gains moving down to 15%. Review the solution spreadsheet. Tweak the figures to see how it affects the results.
With the stated assumptions, here are the outcomes.
A. High Taxes: The NPV for buying this sign is positive at $2916. That is the present value of all the cash flows in and out, discounted by AJ’s risk-adjusted discount rate of 18%. It is positive. That is the good news, but it is not compelling, given all financial analyses have uncertainty in the assumptions. AJ is unsure what to do.
This is the situation for many
people in business today.
B. Low Taxes (static scoring): If the Federal tax rates were lowered back to the Bush years, and still assuming the increased revenues from the sign is 10%, the NPV become $6795. This is an improved picture for AJ, but he is still not overwhelmed at this outcome, given he has to pop $60,000 for the new sign.
C. Lower Taxes (dynamic scoring): Recognizing that lower taxes will spur the economy and his customers should grow given that scenario, AJ sees a much-improved picture. The NPV with a 20% increase in revenues, partly from the sign and partly from the improved economy, is now a compelling $52,726! If AJ really thinks that lowered tax rates are in the future, he will go ahead with his major purchase.
AJ is indicative of many small business people and also a microcosm of the CEOs of big businesses in the US. There is too much uncertainty to make major purchases.
Some writers believe there is $1 trillion dollars of cash awaiting the reduction of uncertainty that has existed since the start of this long recession. Let’s hope the economy begins to sprint now that at least there is some reduction of uncertainty since the fiscal cliff tax debate is over.
You can find the spreadsheet solution to this NPV practice problem by clicking here.