Problem 11-36 (LO. 2, 11)

Heather wants to invest $40,000 in a relatively safe venture and has discovered two alternatives that would produce the following reportable ordinary income and loss over the next three years:

Year	Alternative 1 Income (Loss)			Alternative 2 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 Heather's investment portfolio produces sufficient passive activity income to offset any potential passive activity loss that may arise from these alternatives, that her cost of capital is 6%, that she is in the 24% tax bracket, that each investment alternative possesses equal growth potential, and that each alternative exposes her to comparable financial risk.

In addition, assume that 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), whereas in those years when the income is positive, cash flows to Heather equal the amount of the income.

a. Based on these facts, compute the present value (PV) of these two investment alternatives. Round each present value (PV) to the nearest dollar.

The present value factors at 6% are as follows: Year 1: 0.9434, Year 2: 0.8900 and Year 3: 0.8396.

Alternative 1

Income (Loss)

Tax Cost/ Benefit

After-Tax Benefit

Present Value

Year 1

($20,000)

$fill in the blank 1

$fill in the blank 2

$fill in the blank 3

Year 2

(28,000)

$fill in the blank 4

$fill in the blank 5

$fill in the blank 6

Year 3

72,000

$fill in the blank 7

$fill in the blank 8

$fill in the blank 9

Total present value

$fill in the blank 10

Alternative 2

Income (Loss)

Tax Cost/ Benefit

After-Tax Benefit

Present Value

Year 1

($48,000)

$fill in the blank 11

$fill in the blank 12

$fill in the blank 13

Year 2

32,000

$fill in the blank 14

$fill in the blank 15

$fill in the blank 16

Year 3

40,000

$fill in the blank 17

$fill in the blank 18

$fill in the blank 19

Total present value

$fill in the blank 20

b.

Alternative 2'sAlternative 1'sAlternative 2's

benefit is greater primarily because of the flow of the benefits and the effect of the at-risk rules on those benefits.