Question
Heather wants to invest $40,000 in a relatively safe venture and has discovered two alternatives that would produce the following ordinary income and loss over
Heather wants to invest $40,000 in a relatively safe venture and has discovered two alternatives that would produce the following ordinary income and loss over the next three years:
Alternate 1 Alternate 2
Year Income (Loss) Income (Loss)
1 ($20,000) ($48,000)
2 (28,000) 32,000
3 72,000 40,000
She is interested in the after-tax effects of these alternatives over a three-year horizon. Assume that:
Heathers investment portfolio produces sufficient passive activity income to offset any potential passive activity loss that may arise from these alternatives.
Heathers marginal tax rate is 25% and her cost of capital is 6% (see Appendix F for the present value factors).
Each investment alternative possesses equal growth potential and comparable financial risk.
In the loss years for each alternative, there is no cash flow from or to the investment (i.e., the loss is due to depreciation), while in those years when the income is positive, cash flows to Heather equal the amount of the income.
Based on these facts, compute the present value of these two investment alternatives and determine which option Heather should choose.
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