Deck 3: Taxes As Transaction Costs

Question 1

The tax savings from a transaction represents a cash inflow.

Answer 1

True

Question 2

Mr. Jessel sold 4,200 shares of stock in a publicly held corporation through his stock broker. This transaction occurred in a private market.

Answer 2

False

Question 3

The before-tax cash flow and after-tax cash flow from a nontaxable transaction are equal.

Answer 3

True

Question 4

Tax law uncertainty is the risk that the Internal Revenue Service will challenge a taxpayer's tax treatment on audit.

Question 5

When the tax law applies differentially to transaction alternatives, decisions should focus on before-tax earnings.

Question 6

Net cash flow from a transaction equals the difference between cash received and cash disbursed in the transaction.

Question 7

The present value of a dollar available in a future period increases as the discount rate increases.

Question 8

Marginal rate uncertainty includes the risk that Congress will change tax rates, increasing the tax costs of future income.

Question 9

An increase in the risk associated with a future stream of cash should result in an increase in the discount rate used in the present value calculation.

Question 10

The tax cost of an income-generating transaction increases as the taxpayer's marginal tax rate increases.

Question 11

The tax cost of a transaction depends on the taxpayer's average tax rate for the year.

Question 12

The tax cost of a transaction represents a cash inflow.

Question 13

Every business transaction results in a current tax cost or tax savings.

Question 14

A dollar available today is always worth more than a dollar not available until a future period.

Question 15

Mr. and Mrs. Bing purchased a business from Ms. Clark in an arm's length transaction. This transaction occurred in a private market.

Question 16

The tax savings from a deduction decreases as the taxpayer's marginal tax rate increases.

Question 17

A cash flow consisting of a constant dollar amount to be received for a specific number of future periods is called an annuity.

Question 18

A taxpayer's marginal tax rate and discount rate are independent variables in the NPV calculation.

Question 19

A deduction is worth twice as much to a taxpayer with a 30% marginal rate than to a taxpayer with a 15% rate.

Question 20

A business strategy that reduces the tax cost of a transaction always increases the NPV of the transaction.

Question 21

Omar Inc. paid a $24,000 expense, only $18,000 of which was deductible. If Omar's marginal tax rate is 40%, compute the after-tax cost of the expense.

A) $24,000
B) $18,000
C) $16,800
D) $10,800

Question 22

Mrs. Scott received a $12,000 cash payment. If her marginal tax rate is 40%, which of the following statements is true?

A) If only $9,200 of the payment is taxable income, her after-tax cash flow is $9,200.
B) If the payment is not taxable income, her after-tax cash flow is $12,000.
C) If the payment is taxable income, her after-tax cash flow is $4,800.
D) None of the above is true.

Question 23

The IRS scrutinizes related party transactions more carefully than transactions occurring in a public market.

Question 24

Related party transactions occur in a public market.

Question 25

Ms. Lenz has $100,000 in an investment paying 9% annual interest. Her marginal tax rate is 25%. Which of the following statements is false?

A) Ms. Lenz's annual before-tax cash flow from this investment is $9,000.
B) If the interest is tax-exempt, Ms. Lenz's annual after-tax cash flow is $9,000.
C) If the interest is taxable, Ms. Lenz's annual after-tax cash flow is $6,750.
D) None of the above is false.

Question 26

Which of the following statements about discount rates is false?

A) A discount rate for computing NPV cannot change from one period to the next.
B) The discount rate for a risky investment should be higher than the discount rate for a risk-free investment.
C) Discount rates can be applied either to the cash flow from a transaction or the taxable income from a transaction.
D) Both a discount rate for computing NPV cannot change from one period to the next and discount rates can be applied either to the cash flow from a transaction or the taxable income from a transaction.

Question 27

Ms. Teague incurred a $35,000 expense. If her marginal tax rate is 20%, which of the following statements is true?

A) If the expense is nondeductible, Ms. Teague's after-tax cost is zero.
B) If the expense is deductible, Ms. Teague's after-tax cost is $28,000.
C) If only $17,500 of the expense is deductible, Ms. Teague's after-tax cost is $14,000.
D) If the expense is nondeductible, Ms. Teague's after-tax cost is zero and, if the expense is deductible, Ms. Teague's after-tax cost is $28,000.

Question 28

The tax law prohibits related party transactions.

Question 29

BMX Company engaged in a current-year transaction that generated a $20,000 cash inflow. Which of the following statements is false?

A) If the cash inflow is not taxable income, the current-year tax cost of the transaction is zero.
B) If the cash inflow is taxable income and BMX's marginal tax rate is 25%, the tax cost of the transaction is $5,000.
C) If the cash inflow is taxable income and BMX's marginal tax rate is 35%, the tax cost of the transaction is $7,000.
D) None of the above is false.

Question 30

KRU Company engaged in a current-year transaction that required a $20,000 cash outflow. Which of the following statements is true?

A) If the cash outflow is deductible and BMX's marginal tax rate is 20%, the tax savings from the transaction is $4,000.
B) If the cash outflow is deductible and BMX's marginal tax rate is 30%, the tax cost of the transaction is $6,000.
C) If the cash outflow is not deductible, the current-year tax savings of the transaction is zero.
D) All of the above are true.

Question 31

Use the present value tables included in Appendix A of your textbook to compute the NPV of $12,500 received in year 5 at a 6% discount rate.

A) $8,745.5
B) $9,337.5
C) $9,900
D) None of the above

Question 32

Use the present value tables included in Appendix B of your textbook to compute the NPV of four $25,000 payments received in years 0, 1, 2, and 3 at a 5% discount rate.

A) $93,075
B) $88,650
C) $81,445.50
D) None of the above

Question 33

Use the present value tables included in Appendix A of your textbook to compute the NPV of $8,400 received in year 0, $4,950 received in year 1, and $3,000 received in year 2 at a 7% discount rate.

A) $14,018
B) $14,623.35
C) $15,647.25
D) None of the above

Question 34

Mr. Trail engaged in a current-year transaction generating $50,000 cash but only $40,000 taxable income. If Mr. Trail's marginal tax rate is 40%, compute his after-tax cash flow from the transaction.

A) $20,000
B) $24,000
C) $34,000
D) $40,000

Question 35

Omar Inc. paid a $24,000 expense, only $10,000 of which was deductible. Which of the following statements is false?

A) If Omar's marginal tax rate is 10%, the after-tax cost of the expense is $9,000.
B) Regardless of Omar's marginal tax rate, the before-tax cost of the expense is $24,000.
C) If Omar's marginal tax rate is 30%, the after-tax cost of the expense is $21,000.
D) The after-tax cost of the expense depends on Omar's marginal tax rate.

Question 36

Which of the following statements about marginal tax rates is true?

A) A taxpayer's marginal rate can change with every transaction.
B) As the marginal rate increases, the tax cost of an income-generating transaction decreases.
C) As the marginal rate increases, the tax savings from a deduction increases.
D) Both a taxpayer's marginal rate can change with every transaction and, as the marginal rate increase, the tax savings from a deduction increases.

Question 37

Which of the following statements about discount rates is true?

A) The higher the marginal tax rate, the higher the discount rate for future cash flows should be.
B) The higher the degree of risk involved in a transaction, the higher the discount rate for future cash flows should be.
C) The longer the time period over which a transaction will generate cash flows, the higher the discount rate should be.
D) The greater the amount of cash generated by a transaction, the higher the discount rate should be.

Question 38

Private market transactions create an opportunity for bilateral tax planning.

Question 39

The arm's length transaction presumption is unreliable for transactions between related parties.

Question 40

Which of the following statements about marginal tax rates is false?

A) A taxpayer's marginal rate does not change over time.
B) As the marginal rate decreases, the after-tax cost of a deductible expense increases.
C) As the marginal rate decreases, the after-tax value of an income-generating transaction increases.
D) Both a taxpayer's marginal rate does not change over time and, as the marginal rate decreases, the after-tax cost of a deductible expense increases.

Question 41

Rarke Company must choose between two alternate transactions. Transaction 1 requires a $20,000 nondeductible cash outlay, while transaction 2 requires a $25,000 deductible cash outlay. Determine the marginal tax rate at which the after-tax costs of the two transactions are equal.

A) 15%
B) 20%
C) 25%
D) 30%

Question 42

Which of the following statements about different tax rates over time is false?

A) A 5% increase in the tax rate for year 10 has less effect on NPV than a 5% increase in the tax rate for year 4.
B) Future tax rates used in NPV calculations are estimates because Congress can change the statutory rates every year.
C) A NPV calculation must assume a constant tax rate for all future periods.
D) A firm's future tax rate may change because of increases or decreases in future taxable income.

Question 43

If a taxpayer decides to take advantage of an ambiguous tax issue to reduce future tax costs, the decision increases:

A) Financial risk
B) Audit risk
C) Tax law uncertainty
D) Marginal tax rate uncertainty

Question 44

Ms. Kent has $200,000 in an investment paying 8% annual interest. Her marginal tax rate is 40%. Which of the following statements is false?

A) Ms. Kent's annual before-tax cash flow from this investment is $16,000.
B) If the interest is tax-exempt, Ms. Kent's annual after-tax cash flow is $16,000.
C) If the interest is taxable, Ms. Kent's annual after-tax cash flow is $6,400.
D) None of the above is false.

Question 45

Holter Inc. owns an investment that generated $120,000 cash revenue and required $26,500 cash expenses this year. Holter's marginal tax rate is 30%. Which of the following statements is false?

A) Holter's before-tax cash flow is $93,500.
B) If the revenue is taxable, but only $19,000 of the expenses are deductible, Holter's after-tax cash flow is $63,200.
C) If only $105,000 of the revenue is taxable, but all the expenses are deductible, Holter's after-tax cash flow is $69,950.
D) None of the above is false.

Question 46

Leto Inc. has $500,000 in an investment paying 8% annual taxable interest. Each year, the corporation incurs a $3,000 nondeductible cash expense relating to the investment. If Leto's marginal tax rate is 35%, compute the annual after-tax cash flow.

A) $23,000
B) $24,050
C) $37,000
D) None of the above.

Question 47

Unlow Inc. must choose between two alternate transactions. Transaction 1 would generate $160,000 cash, all of which would be taxable, while transaction 2 would generate $120,000 cash, none of which would be taxable. Determine the marginal tax rate at which the after-tax cash flows from the two transactions are equal.

A) 15%
B) 20%
C) 25%
D) 30%

Question 48

Reid Inc. received a $90,000 cash payment, only $50,000 of which was taxable income. If Reid's marginal tax rate is 40%, compute Reid's after-tax cash flow.

A) $54,000
B) $50,000
C) $30,000
D) None of the above

Question 49

If Congress enacts a temporary change in the tax law that will apply for only two taxable years, the change increases:

A) Market risk
B) Financial risk
C) Audit risk
D) Tax law uncertainty

Question 50

Ms. Leik has $50,000 in an investment paying 10% annual interest. Each year, she incurs a $600 cash expense relating to the investment. If Ms. Leik's marginal tax rate is 20%, which of the following statements is true?

A) Ms. Leik's annual after-tax cash flow from this investment is $3,520.
B) If the interest is taxable but the expense is not deductible, Ms. Leik's annual after-tax cash flow from the investment is $3,400.
C) If the interest is tax-exempt and the expense is not deductible, Ms. Leik's annual after-tax cash flow is $5,000.
D) None of the above is true.

Question 51

Mr. Basel made an investment that will generate the following cash flows over a three-year period. If Mr. Basel's marginal tax rate over the three year period is 20% and he uses a 6% discount rate, compute the NPV of the transaction.

A) $30,028
B) $33,557
C) $39,781
D) None of the above

Question 52

Mr. and Mrs. Rath invested in a business that will generate the following cash flows over a three-year period. If the Raths' marginal tax rate over the three year period is 20% and they use a 6% discount rate, compute the NPV of the transaction.

A) $59,340
B) $55,996
C) $50,413
D) None of the above

Question 53

Hower Inc.'s tax advisor recommends that the corporation take a deduction that the IRS has disallowed for other corporations in similar circumstances. If Hower decides not to take the deduction, it is reducing:

A) Audit risk
B) Tax law uncertainty
C) Business risk
D) None of the above

Question 54

XYT Company engaged in a transaction that generated $50,000 cash deposited in the company bank account and required the company to pay $12,000 out of that account. XYT's marginal tax rate is 30%. Which of the following statements is false?

A) If the deposit is taxable income and the payment is deductible, the transaction generated $26,600 after-tax cash flow.
B) If the deposit is taxable income but the payment is nondeductible, the transaction generated $35,000 after-tax cash flow.
C) If the deposit is not taxable income and the payment is nondeductible, the transaction generated $38,000 after-tax cash flow.
D) None of the above is false.

Question 55

Mr. Wills invested in a business that will generate $75,000 annual after-tax cash flow in years 0 and 1 and $90,000 annual after-tax cash flow in years 2 and 3. Compute the NPV of these cash flows at a 10% discount rate.

A) $259,185
B) $277,348
C) $290,310
D) None of the above

Question 56

Mr. and Mrs. Dean own an investment that generated $60,000 cash revenue and required $12,000 cash expenses this year. The Deans' marginal tax rate is 25%. Which of the following statements is true?

A) If only $52,000 of the revenue is taxable, but all the expenses are deductible, the Deans' after-tax cash flow is $40,000.
B) If the revenue is taxable, but only $8,500 of the expenses are deductible, the Deans' after-tax cash flow is $38,625.
C) The Deans' before-tax cash flow is $48,000.
D) Both if the revenue is taxable, but only $8,500 of the expenses are deductible, the Deans' after-tax cash flow is $38,625 and the Deans' before-tax cash flow is $48,000.

Question 57

Mrs. Biggs invested in a business that will generate the following cash flows over a three-year period. If Mrs. Biggs' marginal tax rate over the three year period is 30% and she uses a 6% discount rate, compute the NPV of the transaction.

A) $61,453
B) $52,771
C) $47,781
D) None of the above

Question 58

Mr. Quest plans to engage in a transaction that will generate $10,000 cash flow in year 0, year 1, and year 2 ($30,000 total cash flow). Which of the following statements is true?

A) If the cash flow is not taxable income, the before-tax and after-tax cash flows from the transaction are equal.
B) If the cash flow is not taxable income, the NPV of the transaction is $30,000.
C) Mr. Quest's discount rate for computing the NPV of the transaction depends on his marginal tax rate.
D) None of the above is true.

Question 59

If Congress enacts legislation late in the year that is retroactive to the beginning of the year, the legislation increases:

A) Audit risk
B) Tax law uncertainty
C) Financial risk
D) Marginal tax rate uncertainty

Question 60

Ms. Card bought an investment that will generate the following cash flows over a three-year period. If Ms. Card's marginal tax rate over the three year period is 40% and she uses a 6% discount rate, compute the NPV of the transaction.

A) $94,129
B) $84,964
C) $62,373
D) None of the above

Question 61

Which of the following is not a related party transaction?

A) Acme Corporation leases office space to Norton Company. Mr. and Mrs. Norton own Norton Company and 65% of Acme Corporation's stock.
B) BBD Inc. licenses a patent from Nugo Inc., which owns 82% of BBD's outstanding stock.
C) Beth Teal pays $15,000 a year to her gardener, Ben. Beth is Ben's grandmother.
D) All the transactions are between related parties.

Question 62

Which of the following statement about private market transactions is false?

A) Both parties have flexibility in determining the legal and financial characteristics of the transaction.
B) The parties negotiate directly with each other.
C) The parties are dealing at arm's length.
D) The parties must engage in unilateral instead of bilateral tax planning.

Question 63

Arm's length business transactions can occur in:

A) Private markets
B) Public markets
C) Fictitious markets
D) Both private and public markets

Question 64

Which of the following statements about related party transactions is false?

A) The transaction may lack the economic tension characteristic of a transaction between unrelated parties.
B) The transaction may reflect a fictitious market.
C) The parties to the transaction may have compatible financial objectives.
D) None of the above is false.

Question 65

When the IRS audits a tax return, it is most likely to scrutinize the tax consequences of a/an:

A) Related party transaction
B) Private market transaction
C) Public market transaction
D) Arm's length transaction

Question 66

Pepper Company, which has a 25% marginal tax rate, must choose between two alternative transactions. Transaction 1 requires a $20,400 cash outlay that is a deductible current expense. Transaction 2 requires a $15,000 cash outlay that is a nondeductible current expense. Which transaction has the lesser after-tax cost to Pepper?

Question 67

Yawl Inc. must choose between two business opportunities. Opportunity 1 will generate $40,000 before-tax cash flow in years 0, 1, and 2, with a $7,000 annual tax cost.
Opportunity 2 will also generate $40,000 before-tax cash flow in years 0, 1, and 2. However, the tax cost will be $15,000 in year 0, $2,500 in year 2, and $2,500 in year 3. Which opportunity should Yawl choose if it uses a 6% discount rate to compute NPV?

Question 68

Mrs. Scott loaned $100,000 to her daughter Evelyn, who agreed to pay her mother $3,000 annual interest on the debt. This loan is an example of a/an:

A) Prohibited transaction
B) Public market transaction
C) Related party transaction
D) Arm's length transaction

Question 69

Ms. Owen purchased 2,000 shares of General Electric common stock through her broker. This purchase is an example of a:

A) Public market transaction
B) Fictitious market transaction
C) Private market transaction
D) Related party transaction

Question 70

Citran Company will earn $150,000 revenue as payment for a three-year consulting engagement. Compute the NPV of the revenue if Citran will receive $35,000 cash immediately (year 0), $35,000 cash next year (year 1) and $80,000 cash the following year (year 2). Citran will report the revenue as taxable income in the year received. Its marginal tax rate is 30%, and it uses an 8% discount rate.

Question 71

Late in the current year, Jolsen Company signed a four-year contract with an advertising agency. Under the contract, Jolsen must pay $375,000 annually for the agency's services. After Jolsen signed the contract, Congress enacted legislation disallowing any deduction for advertising expense for future tax years. Jolsen underestimated the after-tax cost of the contract because of:

A) Marginal tax rate uncertainty
B) Financial risk
C) Audit risk
D) Tax law uncertainty

Question 72

TallBoy Inc. is a local furniture manufacturer and Leley Company is a retail furniture store. The two companies have no owners in common. Leley recently negotiated to purchase $845,000 of furniture from TallBoy. This purchase is an example of a/an:

A) Related party transaction
B) Public market transaction
C) Arm's length transaction
D) None of the above

Question 73

Which of the following statements concerning related party transactions is true?

A) The federal tax law prohibits related party transactions.
B) Related parties enjoy significant flexibility in controlling the tax consequences of their transactions.
C) Related party transactions can never reflect an arm's length standard.
D) The IRS always disallows any favorable tax consequences of related party transactions.

Question 74

Angela Jones is considering two investments. The first produces $5,000 of tax-exempt income. The second produces income that will be subject to tax at a rate of 15%. Which of the following statements is true regarding Angela's choice?

A) Angela should always choose the first investment because it minimizes her tax costs.
B) If the second investment generates $5,500 of before-tax income, Angela should choose the first investment.
C) If the second investment generates $6,500 of before-tax income, Angela should choose the second investment.
D) Both B. and C. are true.

Question 75

The transacting parties can engage in bilateral tax planning when a transaction occurs in a:

A) Public market
B) Private market
C) Secondary market
D) None of the above

Question 76

Which of the following statements about tax minimization is true?

A) Tax minimization always maximizes the NPV of a transaction.
B) Tax minimization should be the goal of business and financial planning.
C) Tax minimization with respect to a transaction may not be the optimal strategy.
D) Tax minimization has no effect on nontax cash flows.

Question 77

Which of the following statements about public market transactions is true?

A) The parties negotiate directly with each other.
B) The parties must engage in unilateral instead of bilateral tax planning.
C) The parties are not transacting at arm's length.
D) Both parties have flexibility in determining the legal and financial characteristics of the transaction.

Question 78

Mr. Vail made an offer to purchase a business for sale by Mr. Craig. Mr. Vail and Mr. Craig had never met prior to their negotiation of the terms of the sale. The sale is an example of a/an:

A) Arm's length transaction B
B) Private market transaction
C) Public market transaction
D) Both A. and B.

Question 79

The arm's length transaction presumption:

A) Assumes that each party is dealing in its own economic self-interest.
B) Cannot be satisfied in a private market transaction.
C) Requires direct negotiation between parties to ensure an arm's length price.
D) Applies to both related party and unrelated party transactions.

Question 80

Zazu Company is considering modifying a transaction to reduce the current year tax cost by $50,000. Which of the following statements is false?

A) The modification will increase the NPV of the transaction by $50,000.
B) The modification may affect the transaction's before-tax cash flows.
C) The modification may reduce the tax cost but increase one or more nontax costs.
D) The modification may not be desirable even though it reduces the tax cost.