Taxes are costs to doing businesses, 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 less valuable or even

obsolete.

Q1 Taxes are costs to doing businesses, 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 fims. Indeed, unless new investment incentives increase consumer demand, they can work only by rendering existing equipment less valuable or even 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: 1 2 3 0 1. Initial investment 100 2. Revenues 3. Fixed operating costs 4. Depreciation 5. Income pretax 6. Tax at 40% 7. Net income 8. After-tax salvage 9. Cash flow (7 +8+4-1) - 100 NPV at WACC=20% is o 100 50 33.33 16.67 6.67 10 100 50 33.33 16.67 6.67 10 100 50 33.33 16.67 6.67 10 15 +58.33 +43.33 +43.33 a. What is the value of a one-year-old plant? Of a two-year-old plant? b. Suppose that the goverment now changes tax depreciation to allow 40% depreciation in year 1, 40% depreciation in year 2 and 20% depreciation in year 3. What is the NPV of a new plant? How does the change in depreciation rule affect the NPV of the new plant? c. Now assume that the business is very competitive, so following the change in depreciation rule, the revenue of a bucolic acid plant would decline. What will the revenue be? (The competitiveness of the business means all new plants should have zero NPV.) d. Given the revenue you get in (c). what is the value of a one-year-old plant? Of a two-year- old plant? Now what's your thought about the effect of the change in depreciation rule