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Kimo Company is a cash-basis, calendar-year sole proprietorship
Kimo Company is a cash-basis, calendar-year sole proprietorship. The owner, Karina, is in the 24 percent marginal tax bracket this year. Kimo owes a $15,000 expense that it may pay before the end of this year or in January of next year. a. If Karina expects her marginal tax rate to be 24 percent next year, should Kimo pay the expense this year or next? Use a 7 percent discount factor to explain your answer. b. How would your answer change if Karina's expected marginal tax rate next year is only 22 per- cent? Explain. c. How would your answer change if Karina's expected marginal tax rate next year is 32 percent? Explain.
Expert Solution
a.)Because Kimo’s marginal tax rate is expected to be the same, the only consideration is the time value of money.If Kimo chooses to pay the expense in year 1, it will have an after-tax savings of $3,600 ($15,000 x 24%).If Kimo defers payment of the expense, its net present value of the after-tax savings will be $3,366 ($15,000 x 24% x .935 PV factor).Therefore, Kimo should pay the expense in year 1 since it will result in a $234 greater after-tax savings($3,600 - $3,366).
b).If Kimo’s marginal tax rate is expected to decrease to 22%, Kimo will have a lower after-tax savings in year 2.The net present value of Kimo’s after-tax savings would be $3,085.5 ($15,000 x 22% x .935 PV factor).Kimo should pay the expense in year 1 since it will result in a $514.5 greater after-tax savings($3,600 - $3,085.5).
C) if Kimo’s marginal tax rate is expected to increase to 32%, Kimo will have agreater after-tax savings in year 2.The net present value of Kimo’s after-tax savings would be $4,488 ($15,000 x 32% x .935 PV factor).Kimo should wait and pay the expense in year 2 since it will result in a $888 greater after-taxsavings ($4,488 - $3600)
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