Suppose you operate a very profitable sole proprietorship. Your current-year marginal tax rate (including self-employment taxes) is 35%, but you expect it to increase to 50% next year due to legislative changes.

Your business includes exclusive rights to distribute microcomputer software packages in specified geographical areas. Your typical gross margin on software sales is an impressive 50%. Sales revenue is recognized when you ship the software. Under your normal credit terms, customers have 30 days from the invoice date to pay for the software before you begin to charge interest on unpaid balances.

The end of the year is approaching and you wonder whether a special price reduction to promote sales in the current tax year would be desirable. You believe that a 10% across-the-board price reduction for the remainder of the year would have the following effects:

• $400,000 of sales to new customers would be generated this year. However, because you need to expedite these sales, you would be unable to perform the normal credit checks for these customers. You believe that 10% of these sales might ultimately be uncollectible, resulting in $40,000 of bad debt expense next year.
• $800,000 of sales that would have occurred anyway this year will be discounted by 10%, thereby yielding only $720,000 in revenue.
• $500,000 of sales that would have occurred next year will be accelerated into this year, but at a 10% discount, thereby yielding only $450,000 in revenue this year.

Required:

a. How much better or worse off would you be on a before- and after-tax basis if you employ the discounting strategy and it goes according to plan?

You might find it helpful to use the following worksheets. Because were talking about cash flow shifts over a relatively short time period (e.g. a month or so), you may ignore the time value of money.

Before- and After-tax Results WITHOUT the Discounting Plan

THIS YEARNEXT YEARBOTH YEARSales Revenue- Cost of Goods Sold- Bad Debt ExpenseTotal Gross Profit- Income taxAfter-Tax Profit

Before- and After-tax Results WITH the Discounting Plan

THIS YEARNEXT YEARBOTH YEARSales Revenue- Cost of Goods Sold- Bad Debt ExpenseTotal Gross Profit- Income taxAfter-Tax Profit

b. Your customers fall into three categories, as shown below. How are these groups (clienteles) likely to respond differently to your temporary price cut?

1. Corporations that use your software. Their tax rates will not change across years.
2. Retail stores that sell to individuals who are not entitled to tax deductions for the purchase of your software.
3. Small businesses, many of whom face tax rate increases similar to yours. These businesses take tax deductions for the purchase of software in the year it is acquired.

Suppose the tax rate is 30% if taxable income is positive and 0% if taxable income is negative. Thus, the rate structure is steeply progressive. Consider the before-tax payoffs to the following three projects:[1]

a. Riskless: 10% for sure

b. Moderately risky: 30% half the time 10% half the time

c. Quite risky: 300% one time in 10 20% nine times out of 10

Required:

(1) Calculate the before-tax and after-tax expected rates of return for each project.

(2) How does the variability of returns affect the expected tax rate? Why?

(3) Does this tax structure encourage or discourage risky start-up ventures?

[1] This problem is adapted from Scholes, et al. 2005. Taxes and Business Strategy: A Planning Approach, 3^rd Edition, Prentice Hall (page 179).