1. Consider an economy in which firms produce output using two types of capital inputs, equipment (E) and structures (S). Firms are 100% equity financed and investors require a minimum (hurdle) rate of return (p) of 10% on all capital investments. Both equipment and structures have an economic depreciation rate of 15% per year (g = ds = .15). The opportunity cost of equity finance is not deductible for tax purposes, there is no sales tax on capital, there is no investment tax credit, and the inflation rate is zero. In the initial setting, the corporate tax rate is 50% and investment in equipment are expensed immediately for tax purpose, while investments in structures are deducted at a declining balance CCA rate a that is equal to the economic depreciation rate os.

(a) Determine the before tax net of depreciation minimum required rate of return (r) for both equipment and structures. What is the marginal effective tax rate (METR) on equipment and structures respectively?

(b) Now say that the CCA rate for structures is set to 10% rather than the economic depreciation rate. Now what is the before-tax net of depreciation minimum required rate of return and the marginal effective tax rate on structures?

(c) Say that the firm's production function is given by F(ES) = 0.25, and it chooses E and S to maximize its (per period) profits, which are equal to: T = F(ES)-(+) E-(18+ 8)S Determine the firm's output if both equipment and structures can be immediately expensed for tax purposes, and compare this with the output when equipment can be expensed while the CCA rate for structures is equal to the economic rate of depreciation (as in part a)). (HINT: The firm chooses E and S such that = 0 and = 0)