Ms. Keri Lee, an expert in retrofitting buildings to meet seismic safety standards, has just received a $200,000 after-tax bonus for the successful completion of a project on time and under budget. Business has been so good that she is planning to retire in 12 years, spending her time relaxing in the sun, skiing, and doing charitable work. Ms. Lee is considering two alternatives for investing her bonus.
Alternative 1. Municipal bonds can be purchased that mature in 12 years and that bear interest at
8%. This interest would be tax-free and paid semiannually. (In discounting a cash flow that occurs semiannually, the procedure is to halve the discount rate and double the number of periods. Use the same procedure for discounting the principal returned when the bonds reach maturity.)
Alternative 2. A small discount perfume shop is available for sale at a nearby factory outlet center. The business can be purchased from its current owner for $200,000. The following information relates to this alternative:
a. Of the purchase price, $80,000 would be for fixtures and other depreciable items. The remainder would be for the company’s working capital (inventory, accounts receivable, and cash). The fixtures and other depreciable items would have a remaining useful life of at least 12 years but would be depreciated for tax reporting purposes over eight years using the following allowances published by the Internal Revenue Service:
Percentage of Original
Year Cost Depreciated
1 . . . . . . . . . . . . . 14.3%
2 . . . . . . . . . . . . . . . 24.5
3 . . . . . . . . . . . . . . . 17.5
4 . . . . . . . . . . . . . . . 12.5
5 . . . . . . . . . . . . . . . .8.9
6 . . . . . . . . . . . . . . . .8.9
7 . . . . . . . . . . . . . . . 8.9
8 . . . . . . . . . . . . . . . .4.5
100.0%
Salvage value is not deducted when computing depreciation for tax purposes. At any rate, at the end of 12 years, these depreciable items would have a negligible Salvage value; however, the working capital would be released for reinvestment elsewhere.
b. Store records indicate that sales have averaged $400,000 per year, and out-of-pocket costs have averaged $370,000 per year ( not including income taxes). These out-of-pocket costs include rent on the building, cost of goods sold, utilities, and wages and salaries for the sales staff and the store manager. Ms. Lee plans to entrust the day-to-day operations of the store to the manager.
c. Ms. Lee’s tax rate is 40%.
Required:
Advise Ms. Lee as to which alternative should be selected. Use the total-cost approach to discounted cash flow in your analysis and a discount rate of 8%. (Round all dollar amounts to the nearest whole dollar.)