The legislature is considering changing tax rates from 7 percent to either 6 percent or 5 percent. Pathways Landscaping Equipment is trying to understand the impact of these changes and is using scenario analysis to assess the expected value of the impact. Before any changes are made, the base case scenario is $1,000,000 in annual taxable income at a tax rate of 7 percent. The following table summarizes the expected financial impact of each scenario, assuming that taxable income increases or decreases by 5 percent and either no changes are made in the 7 percent tax rate or the tax rate decreases to either 6 percent or 5 percent. Income Scenario Income increases by 5% Income remains unchanged Income decreases by 5% Taxable Income If Tax Rate = 7%, Taxes Owed = $ 3,500 If Tax Rate = 6%, Taxes Owed = If Tax Rate = 5%, Taxes Owed = $ (7,000) $ (17,500) $ 1,000,000 $ 950,000 0 $ (20,000) $ 1,050,000 $ (3,500) $ (10,000) $ (13,000) $ (22,500) Based on Pathways' assessment of the probability of the tax-law changes and potential changes in its own taxable income, here are the joint probabilities of the changes in tax rate and taxable income. Income increases by 5% Taxable Income $ 1,050,000 Income remains unchanged $ 1,000,000 Income decreases by 5% $ 950,000 Likelihood of Each Scenario If Tax Rate = 7%, Taxes If Tax Rate = 6%, Taxes If Tax Rate = 5%, Taxes Owed = Owed = If Tax Rate = 5% If Tax Rate = 7% 0.05 0.20 0.05 Owed = If Tax Rate = 6% 0.05 0.20 0.1 0.15 0.10 0.1 PR 13-2 (LO 13.4) Now assume that the tax rates are expected... Now assume that the tax rates are expected to change to 8 percent, 7 percent, and 6 percent with the same probabilities as Problem 1. If Tax Rate = 8%, If Tax Rate = 6%, Income Scenario Income increases by 5% Income remains unchanged Income decreases by 5% Required: Taxes Owed = $ 14,000 Taxable Income $ 1,050,000 $ 1,000,000 $ 10,000 $ 950,000 $ 6,000 If Tax Rate = 7%, Taxes Owed = $ 3,500 $ 0 Taxes Owed = $ (7,000) $ (3,500) $ (10,000) $ (13,000) Compute the value of the expected impact of the changes in tax rates on Pathways' tax burden. Note: The goal is to identify the value of the increase or decrease to taxes owed. Decreases to taxes owed should be entered as a negative value. Income Scenario Taxable Income 8% Tax Rate impact 7% Tax Rate If Tax Rate is 6%, impact taxes owed: Income Increases by 5% Income Remains the Same Income Decreases by 5% $ 1,050,000 $ 1,000,000 $ 0 $ 950,000 Sum of all expected changes: $ 0

The legislature is considering changing tax rates from 7 percent to either 6 percent or 5 percent. Pathways Landscaping Equipment is trying to understand the impact of these changes and is using scenario analysis to assess the expected value of the impact. Before any changes are made, the base case scenario is $1,000,000 in annual taxable income at a tax rate of 7 percent. The following table summarizes the expected financial impact of each scenario, assuming that taxable income increases or decreases by 5 percent and either no changes are made in the 7 percent tax rate or the tax rate decreases to either 6 percent or 5 percent. Income Scenario Income increases by 5% Income remains unchanged Income decreases by 5% Taxable Income If Tax Rate = 7%, Taxes Owed = $ 3,500 If Tax Rate = 6%, Taxes Owed = If Tax Rate = 5%, Taxes Owed = $ (7,000) $ (17,500) $ 1,000,000 $ 950,000 0 $ (20,000) $ 1,050,000 $ (3,500) $ (10,000) $ (13,000) $ (22,500) Based on Pathways' assessment of the probability of the tax-law changes and potential changes in its own taxable income, here are the joint probabilities of the changes in tax rate and taxable income. Income increases by 5% Taxable Income $ 1,050,000 Income remains unchanged $ 1,000,000 Income decreases by 5% $ 950,000 Likelihood of Each Scenario If Tax Rate = 7%, Taxes If Tax Rate = 6%, Taxes If Tax Rate = 5%, Taxes Owed = Owed = If Tax Rate = 5% If Tax Rate = 7% 0.05 0.20 0.05 Owed = If Tax Rate = 6% 0.05 0.20 0.1 0.15 0.10 0.1 PR 13-2 (LO 13.4) Now assume that the tax rates are expected... Now assume that the tax rates are expected to change to 8 percent, 7 percent, and 6 percent with the same probabilities as Problem 1. If Tax Rate = 8%, If Tax Rate = 6%, Income Scenario Income increases by 5% Income remains unchanged Income decreases by 5% Required: Taxes Owed = $ 14,000 Taxable Income $ 1,050,000 $ 1,000,000 $ 10,000 $ 950,000 $ 6,000 If Tax Rate = 7%, Taxes Owed = $ 3,500 $ 0 Taxes Owed = $ (7,000) $ (3,500) $ (10,000) $ (13,000) Compute the value of the expected impact of the changes in tax rates on Pathways' tax burden. Note: The goal is to identify the value of the increase or decrease to taxes owed. Decreases to taxes owed should be entered as a negative value. Income Scenario Taxable Income 8% Tax Rate impact 7% Tax Rate If Tax Rate is 6%, impact taxes owed: Income Increases by 5% Income Remains the Same Income Decreases by 5% $ 1,050,000 $ 1,000,000 $ 0 $ 950,000 Sum of all expected changes: $ 0

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter2: Financial Statements, Cash Flow,and Taxes

Section: Chapter Questions

Problem 18P: Rhodes Corporations financial statements are shown after part f. Suppose the federal-plus-state tax...

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