Taxes are a cost, and, therefore, changes in tax rates can affect consumer prices, project lives, and the value of existing firms. The following problem illustrates this. It also illustrates that tax changes that appear to be good for business do not always increase the value of existing firms. Indeed, unless new investment incentives increase consumer demand, they can work only by rendering existing equipment obsolete.

The manufacture of bucolic acid is a competitive business. Demand is steadily expanding, and new plants are constantly being opened. Expected cash flows from an investment in a new plant are as follows:

		0	1	2	3
1.	Initial investment	105
2.	Revenues		105.00	105.00	105.00
3.	Cash operating costs		55.00	55.00	55.00
4.	Tax depreciation		35.00	35.00	35.00
5.	Income pretax		15.00	15.00	15.00
6.	Tax at 35%		5.25	5.25	5.25
7.	Net income		9.75	9.75	9.75
8.	After-tax salvage				19.50
9.	Cash flow (7 + 8 + 4 1)	105	44.75	44.75	64.25
NPV at 20% = 0

Assumptions:

1. Tax depreciation is straight-line over three years.
2. Pretax salvage value is 30 in year 3 and 55 if the asset is scrapped in year 2.
3. Tax on salvage value is 35% of the difference between salvage value and depreciated investment.
4. The cost of capital is 20%.

a. What are the values of a one- and two-year-old plant? b. Existing plans must continue using the original tax depreciation schedule. What are the values of a one- and two-year-old plant? c. Calculate the net-of-tax salvage value of a two-year-old plant. d. Assume the corporate income tax was abolished entirely. What are the values of a one- and two-year-old plant?