Question 18.4: On November 30 of last year your company invested $1,000,000...
On November 30 of last year your company invested $1,000,000 in an office-building complex and has the opportunity to sell its interest in the complex for $1,220,000 in November. If the complex is sold in November, your company will have held the asset for a year or less, and it will be taxed as ordinary income at a rate of 34%. Your company has the option to wait and sell its interest in the complex for $1,200,000 in December. If the complex is sold in December, your company will have held the asset for more than a year and it will be taxed as a long-term capital gain at a rate of 20%. Using a MARR of 15% determine the net present value for each of these sales. Which alternative is more financially attractive?
For this problem all cash flows that occur during the year will be lumped together. Selling the property in November will result in a capital gain of $220,000 ($1,220,000 – $1,000,000) that will be taxed at a rate of 34%. The income tax due on the sale is $74,800 ($220,000 – 0.34) for an after-tax cash flow of $1,145,200. The net present value for this option is calculated using Eq. (15-3) as follows:
P = F/(1 + i)^n (15-3)
NPV = -$1,000,000 + $1,145,200/(1 + 0.15)^1 = -$4,174
Selling the property in December will result in a long term capital gain of $200,000 ($1,200,000 – $1,000,000) that will be taxed at a rate of 20%. The income tax due on the sale is $40,000 ($200,000 × 0.20) for an aftertax cash flow of $1,160,000. The net present value for this option is calculated using Eq. (15-3) as follows:
NPV = -$1,000,000 + $1,160,000/(1 + 0.15)^1 = $8,696
By waiting a month to sell the asset, although the sale price is reduced by $20,000, the price reduction is more than offset by tax savings. In fact, by waiting a month, the net present value of the sale for the asset goes from an unacceptable (a negative) net present value to an acceptable (a positive) net present value.