Chapter 2 Solutions

Chapter-2: Solutions to Problems
P2-1.
Corporate taxes
LG 6; Basic
a. Firms tax liability on $92,500 (from Table 2.1):
Total taxes due $13,750 [0.34 ($92,500 $75,000)]
$13,750 (0.34 $17,500)
$13,750 $5,950
$19,700
b. After-tax earnings: $92,500 $19,700 $72,800
c. Average tax rate: $19,700 $92,500 21.3%
d. Marginal tax rate: 34%
P2-2.
Average corporate tax rates

LG 6; Basic
a. Tax calculations using Table 2.1:
$10,000:
Tax liability:
$10,000 0.15 $1,500
After-tax earnings: $10,000 $1,500 $8,500
Average tax rate: $1,500 $10,000 15%
$80,000:
Tax liability:
$13,750
$13,750
$13,750
$15,450
[0.34 (80,000 $75,000)]

(0.34 $5,000)
$1,700
Total tax
After-tax earnings: $80,000 $15,450

Average tax rate: $15,450 $80,000
$300,000:
Tax liability:
$64,550
19.3%
$22,250 + [0.39 ($300,000 $100,000)]

$22,250 (0.39 $200,000)
$22,250 $78,000
$100,250 Total tax

Average tax rate: $100,250 $300,000 33.4%
$500,000:
Tax liability:
$113,900
$113,900
$113,900
$170,000
[0.34 ($500,000 $335,000)]

(0.34 $165,000)
$56,100
Total tax

Average tax rate: $170,000 $500,000 34%
$1,500,000:
Tax liability:
$113,900
$113,900
$113,900
$510,000
[0.34 ($1,500,000 $335,000)]

(0.34 $1,165,000)
$396,100
Total tax
After-tax earnings: $1,500,000 $510,000

Average tax rate: $510,000 $1,500,000
$10,000,000: Tax liability:
$990,000
34%
$113,900 + [0.34 ($10,000,000 $335,000)]

$113,900 (0.34 $9,665,000)
$113,900 $3,286,100
$3,400,000 Total tax
After-tax earnings: $10,000,000 $3,400,000 $6,600,000

Average tax rate: $3,400,000 $10,000,000 34%
$20,000,000: Tax liability:
$6,416,667
$6,416,667
$6,416,667
$7,000,000
[0.35 ($20,000,000 $18,333,333)]

(0.35 $1,666,667)
583,333
Total tax
After-tax earnings: $20,000,000 $7,000,000 $13,000,000

Average tax rate: $7,000,000 $20,000,000 35%
b.
As income increases, the rate reaches 35%.
P2-3.
Marginal corporate tax rates

LG 6; Basic
a.
Tax Calculation
Pre-tax
Income
Base Tax
Amount
over Base
$ 15,000
60,000
90,000
200,000
400,000
1,000,000
20,000,000
$0
7,500
13,750
22,250
113,900
113,900
6,416,667
(0.15
(0.25
(0.34
(0.39
(0.34
(0.34
(0.35
15,000)
10,000)
15,000)
100,000)
65,000)
665,000)
1,666,667)
Total
Tax
Marginal
Rate
$ 2,250
10,000
18,850
61,250
136,000
340,000
7,00,0000
15.0%
25.0%
34.0%
39.0%
34.0%
34.0%
35.0%
b.
As income increases to $335,000, the marginal tax rate approaches and peaks at 39%. For
income in excess of $335,000, the marginal tax rate declines to 34%, and after $10 million
the marginal rate increases slightly to 35%.
P2-4.
Interest vs. dividend income

LG 6; Intermediate
a. Tax on operating earnings: $490,000
b. and c.
Before-tax amount
Less: Applicable exclusion
Taxable amount
Tax (40%)
After-tax amount
0.40 tax rate
$196,000
(b)
Interest Income
(c)
Dividend Income
$20,000
0
20,000
8,000
12,000
$20,000
14,000
6,000
2,400
17,600
(0.70
$20,000)
d. The after-tax amount of dividends received, $17,600, exceeds the after-tax amount of
interest, $12,000, due to the 70% corporate dividend exclusion. This increases the
attractiveness of stock investments by one corporation in another relative to bond
investments.
e. Total tax liability:
Taxes on operating earnings (from a.)
Taxes on interest income (from b.)
Taxes on dividend income (from c.)
Total tax liability
P2-5.
$196,000
8,000
2,400
$206,400
Interest vs. dividend expense

LG 6; Intermediate
a. EBIT
Less: Interest expense
Earnings before taxes
Less: Taxes (40%)
Earnings after taxes*
$40,000
10,000
$30,000
12,000
$18,000
This is also earnings available to common stockholders.
b. EBIT
Less: Taxes (40%)
Earnings after taxes
Less: Preferred dividends
Earnings available for
common stockholders
$40,000
16,000
$24,000
10,000
$14,000
P2-6.
Capital gains taxes

LG 6; Basic
a. Capital gain:
Asset X $2,250 $2,000 $250
Asset Y $35,000 $30,000 $5,000
b. Tax on sale of asset:
Asset X $250 0.40 $100
Asset Y $5,000 0.40 $2,000
P2-7.
Capital gains taxes

LG 6; Basic
a. and b.
Asset
A
B
C
D
E
Sale Price
(1)
$3,400
12,000
80,000
45,000
18,000
Purchase Price
(2)
$3,000
12,000
62,000
41,000
16,500
Capital Gain
(1)(2)
(3)
$400
0
18,000
4,000
1,500
Tax
(3) 0.40
(4)
$160
0
7,200
1,600
600
P2-8.
Ethics problem
LG 5; Intermediate
The primary ethical issue is whether the insider is basing his buy or sale of company shares on
internal information. If he is basing his decisions on information not available to the general
public, he would be making decisions in an unethical manner. The insider may for instance be
aware of the likelihood of a favorable acquisition, and unethically buy company shares on that
knowledge. On the other hand, insider sales based upon soon-to-be-released information about
the loss of an important contract to a competitor, would also be unethical.

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Chapter-2: Solutions to Problems

Average corporate tax rates

[0.34 (80,000 $75,000)]

After-tax earnings: $80,000 $15,450

$22,250 + [0.39 ($300,000 $100,000)]

After-tax earnings: $300,000 $100,250 $199,750

[0.34 ($500,000 $335,000)]

After-tax earnings: $500,000 $170,000 $330,000

[0.34 ($1,500,000 $335,000)]

After-tax earnings: $1,500,000 $510,000

$113,900 + [0.34 ($10,000,000 $335,000)]

After-tax earnings: $10,000,000 $3,400,000 $6,600,000

[0.35 ($20,000,000 $18,333,333)]

After-tax earnings: $20,000,000 $7,000,000 $13,000,000

As income increases, the rate reaches 35%.

Marginal corporate tax rates

Interest vs. dividend income

0.40 tax rate

Interest vs. dividend expense

This is also earnings available to common stockholders.

Capital gains taxes

Capital gains taxes

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