Al Simpson helped start Excel Systems several years ago. At the time, he purchased116,000 shares of stock at \(1 per share. Now he has the opportunity to sell his interest in the company to Folsom Corp. for \)50 a share in cash. His capital gains tax rate would be 15 percent.

a. If he sells his interest, what will be the value for before-tax profit, taxes, and aftertax profit?

b. Assume, instead of cash, he accepts Folsom Corp. stock valued at \(50 per share. He pays no tax at that time. He holds the stock for five years and then sells it for \)82.50 (the stock pays no cash dividends). What will be the value for before-tax profit, taxes, and aftertax profit five years from now? His capital gains tax is once again 15 percent.

c. Using a 9 percent discount rate, calculate the aftertax profit. That is, discount back the answer in part b for five years and compare it to the answer in part a.

Step by step solution

01

Calculation of after-tax profit

Before-tax profit:

$\begin{array}{rcl}\mathbf{Before}\mathbf{-}\mathbf{Tax}\mathbf{}\mathbf{Profit}& \mathbf{=}& \mathbf{Number}\mathbf{}\mathbf{of}\mathbf{}\mathbf{shares}\mathbf{\times }\mathbf{Price}\mathbf{}\mathbf{Per}\mathbf{}\mathbf{Share}\mathbf{-}\mathbf{Purchase}\mathbf{}\mathbf{Price}\mathbf{}\mathbf{of}\mathbf{}\mathbf{Shares}\\ & \mathbf{=}& \mathbf{116}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{\$}\mathbf{50}\mathbf{-}\mathbf{\$}\mathbf{116}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{684}\mathbf{,}\mathbf{000}\end{array}$

Capital gain tax:

$\begin{array}{rcl}\mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{}\mathbf{Tax}& \mathbf{=}& \mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{\times }\mathbf{Tax}\mathbf{}\mathbf{Rate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{684}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{15}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{852}\mathbf{,}\mathbf{600}\end{array}$

After-tax profit:

$\begin{array}{rcl}\mathbf{After}\mathbf{-}\mathbf{Tax}\mathbf{}\mathbf{Profit}& \mathbf{=}& \mathbf{Profit}\mathbf{}\mathbf{Before}\mathbf{}\mathbf{Tax}\mathbf{-}\mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{}\mathbf{Tax}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{684}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{852}\mathbf{,}\mathbf{600}\\ & \mathbf{=}& \mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{831}\mathbf{,}\mathbf{400}\mathbf{}\end{array}$

02

Calculation of after-tax profit

Before-tax profit

$\begin{array}{rcl}\mathbf{Before}\mathbf{-}\mathbf{Tax}\mathbf{}\mathbf{Profit}& \mathbf{=}& \mathbf{Number}\mathbf{}\mathbf{of}\mathbf{}\mathbf{shares}\mathbf{\times }\mathbf{Price}\mathbf{}\mathbf{Per}\mathbf{}\mathbf{Share}\mathbf{-}\mathbf{Purchase}\mathbf{}\mathbf{Price}\mathbf{}\mathbf{of}\mathbf{}\mathbf{Shares}\\ & \mathbf{=}& \mathbf{116}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{\$}\mathbf{82}\mathbf{.}\mathbf{50}\mathbf{-}\mathbf{\$}\mathbf{116}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{9}\mathbf{,}\mathbf{454}\mathbf{,}\mathbf{000}\end{array}$

Capital gain tax:

$\begin{array}{rcl}\mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{}\mathbf{Tax}& \mathbf{=}& \mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{\times }\mathbf{Tax}\mathbf{}\mathbf{Rate}\\ & \mathbf{=}& \mathbf{\$}\mathbf{9}\mathbf{,}\mathbf{454}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{15}\mathbf{\%}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{418}\mathbf{,}\mathbf{100}\end{array}$

After-tax profit:

$\begin{array}{rcl}\mathbf{After}\mathbf{-}\mathbf{Tax}\mathbf{}\mathbf{Profit}& \mathbf{=}& \mathbf{Profit}\mathbf{}\mathbf{Before}\mathbf{}\mathbf{Tax}\mathbf{-}\mathbf{Capital}\mathbf{}\mathbf{Gain}\mathbf{}\mathbf{Tax}\\ & \mathbf{=}& \mathbf{\$}\mathbf{9}\mathbf{,}\mathbf{454}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{418}\mathbf{,}\mathbf{100}\\ & \mathbf{=}& \mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{035}\mathbf{,}\mathbf{900}\mathbf{}\end{array}$

03

Calculation of after-tax profit five year back

$\begin{array}{rcl}\mathbf{After}\mathbf{-}\mathbf{Tax}\mathbf{}\mathbf{Profit}\mathbf{}\mathbf{Five}\mathbf{}\mathbf{Year}\mathbf{}\mathbf{Back}& \mathbf{=}& \mathbf{After}\mathbf{}\mathbf{Tax}\mathbf{}\mathbf{Profit}\mathbf{\times }\mathbf{PV}\mathbf{}\mathbf{Factor}\mathbf{}\mathbf{of}\mathbf{}\mathbf{9}\mathbf{\%}\mathbf{}\mathbf{Discount}\\ & \mathbf{=}& \mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{035}\mathbf{,}\mathbf{900}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{650}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{223}\mathbf{,}\mathbf{335}\end{array}$

The after-tax profit of five year back is greater than the profit in part a.

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