comparison of investments with different tax effects

CFA Level III Portfolio Management
#1

Its not really a specific area of the CFA question, but I know I should know the answer easily but Im getting confused.

Les suppose a company earns $100MM during a year (as the result of their business activity… let’s say selling cars). The company closes its countable (fiscal) year the 31 of December each year, and it must pay 35% of tax earnings. So, on 30th of December it has to alternatives:

A) It subscribes $100MM to a special kind of fund, which allows the company to avoid from paying earning taxes that year, but with the condition of keeping funds invested for 2 complete years. Funds will have an annual return of 22%. (It might be some government-sponsored fund, which uses collected money to develop specific areas of the economy).

B) It pays $35MM to the government. Invests the rest, $65MM in a mutual fund, earning 26% each year during two years.

It’s obvious the first option is way better than the second one. But my doubt is about the comparison between both.

  1. In the first scenario, should I add a positive cash flow of $35MM ? Someone told me that since the company is avoiding the payment (or liability) of the taxes, it should count as positive cash flow. I this case, if we assume for simplification that returns are 0%, the company in case A at the end of the period will have $135MM, and at the end of case B it will have $65MM. However, I believe it would be double counting the same tax-exempt effect. Adding $35MM is only an accountable issue, not real cash flow. !!!

  2. What is the final result in each case?

  3. How am I supposed to show the comparison? I calculated the PV of the final results in each case, and would like to calculate the return of each one… but if I begin from $100MM in both cases, the return of option B is negative.

The most important question is “1”!!! Thanks for you help!

#2

This is a dumb question.

#3

But either way, buying an investment is not an expense item. So you’re paying tax on $100m, regardless of which investment you pick or how much you spend on it.

#4

This answer is of no help… I`m telling you that this is a special kind of government-sponsored fund.

Again, assume you invest $100MM in the fund, two years, with an annual return of 22%. Or alternatively, you pay $35MM in taxes, invest $65MM in a fund with an annual return of 26%.

We could complicate things more, by assuming returns earned on the investment are also taxed 35% each year, and in both cases occur the same (because these are financial earnings)… also to keep on complicating things we could assume a discount rate of 15% each year… and we could even add some fees: 1,5% management fee in both cases, annually; and 5% one time fee (when subscribed) in the special fund.

But I think it is better to keep it simpler, as originally stated… if no returns were earned, and no discount rate… after two years, in the first case the investor will have $100MM or $135MM? should I count the liability not paid as “income” or would it be double counting it (as I believe)?

WHY?

also please, the other questions…

#5

Why the F would you add $35 million to the first one? Let’s say I make $50k in 2017, I would have paid $10k in taxes, but Trump abolishes income tax. My cash flow would then be $60k?