Finance Homework 3
Six questions on four pages. Please show your setup equations explicitly, and box your answers.
Price bonds per $1,000 of face value, assuming coupons pay semi-annually unless otherwise stated
(as in question 1).
1. A past issue of the
Wall Street Journal
reported that the President signed a new tax measure
into law that requires that taxes on proceeds from the sale of a business must be paid in the year of
the sale, even if the proceeds will be received in installments over a period of years. Small business
owners and brokers are enraged since they cannot typically obtain full bank financing, while large
businesses rarely utilize installment sales, usually getting financing or using stock-sale transactions.
Joseph N. Green, former co-owner of Carthage Mills, an industrial textile company in Cincinnati,
says "We're hot under the collar." As reported by the
"The tax rule went into effect just before
Mr. Green and his partner were to close the sale of their business. The partners had arranged to
receive more than 70% of the sale price in installments. The partners agreed to the deal, but with
resentment. 'We're paying tax now with good dollars for dollars that will be worth a lot less by
the time we get them' Mr. Green says." The new tax law actually did at least three bad things to
Mr. Green: it makes him pay up front, a time-preference effect; it makes him pay taxes in today's
dollars rather than in the possibly inflated dollars he receives the installments in later; and it increases
his risk, since he now must count on the new owners not to wreck the business so they can pay the
installments on which he has already paid tax
he may not have successfully sold the business
for the amount underlying the taxes if the business fails under the new owners).
Examine the first effect, time preference. Suppose Mr. Green sold his share of the mill
for $1,000,000, getting $300,000 right now. The remaining $700,000 is to be received in ten annual
installments of $70,000 each, beginning exactly one year from now. The capital gains tax rate is
20%; assume all taxes are paid instantly upon receipt of the monies. Under the old law, Mr. Green
would pay tax on the installment income as it is received. Mr. Green estimates the comparable-risk
rate of return to be 14%. What is Mr. Green's tax bill under the new law, and what is the present
value of his tax bill under the old law? How much did the change in the law cost Mr. Green?