Taxes are costs, and, therefore, changes in tax rates can affect consumer prices, project lives and the value of existing firms. Evaluate the change in taxation on the valuation of the following project:
(see materials)
Assumptions: Tax depreciation is straight-line over three years. Pre-tax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2. Tax on salvage value is 40% of the difference between salvage value and book value of the investment. The cost of capital is 20%.
Please verify that the information given above yields NPV = 0.
If you decide to terminate the project in year two (2) what would be the NPV of the project?
Suppose that the government now changes tax depreciation to allow a 100% write-off in year one (1). How does this affect your answers to parts a and b above?
Would it now make sense to terminate the project after two rather than three years?
How would your answers change if the corporate income tax were abolished entirely?
Sample Solution
Although costs have increased, the development of new drugs has seen a decline since the 1990s (True cost). The process of pharmaceutical development is long, costly, and uncertain. According to the Food and Drug Administration, the average cost of developing a new drug is $2.6 billion dollars (FDA). Approximately 50% of developed medications reach screening while a low 5% of medications are approved (FDA). With these risks, pharmaceutical companies have fixated on the promotion of their current drugs as opposed to the release of new medications. However, pharmaceutical companies have long justified their pricing by defensively arguing that revenue goes towards the research and development of new medication. In a six year review (2011-2017) of thirteen of the large pharmaceutical companies, 17% of total revenue was spent on research and development with a staggering 60% spent on the marketing of their current products (True). Over the years, pharmaceutical companies have been able to allocate their profits towards their gains. After all, the pharmaceutical industry is a lucrative business that have thrived under the laxity of regulations and have figured out ways to further increase profit margins. As these problems have become more apparent, bills such as Californiaâs drug transparency bill of 2017 have been enacted. This bill mandates these companies to provide 60 day warnings of greater than or equal to 16% price increases (Upenn). Although the idea behind this bill is a step towards better regulations, it has yet to be adapted on a national level.>
Although costs have increased, the development of new drugs has seen a decline since the 1990s (True cost). The process of pharmaceutical development is long, costly, and uncertain. According to the Food and Drug Administration, the average cost of developing a new drug is $2.6 billion dollars (FDA). Approximately 50% of developed medications reach screening while a low 5% of medications are approved (FDA). With these risks, pharmaceutical companies have fixated on the promotion of their current drugs as opposed to the release of new medications. However, pharmaceutical companies have long justified their pricing by defensively arguing that revenue goes towards the research and development of new medication. In a six year review (2011-2017) of thirteen of the large pharmaceutical companies, 17% of total revenue was spent on research and development with a staggering 60% spent on the marketing of their current products (True). Over the years, pharmaceutical companies have been able to allocate their profits towards their gains. After all, the pharmaceutical industry is a lucrative business that have thrived under the laxity of regulations and have figured out ways to further increase profit margins. As these problems have become more apparent, bills such as Californiaâs drug transparency bill of 2017 have been enacted. This bill mandates these companies to provide 60 day warnings of greater than or equal to 16% price increases (Upenn). Although the idea behind this bill is a step towards better regulations, it has yet to be adapted on a national level.>
