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Westerhold Econ 432

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HW#5: Net Present Value, Tax Incidence, and Tax Progressiveness due Wednesday, May 5th. No late assignments will be accepted. 1. The government has hired you to advise them on the merits of a project that is being proposed. The project is expected to generate benefits of 14 million dollars today, 5 million dollars in one year from today, and 1 million dollars in two years from today. (These are the only years of concern.) The project costs nothing today, but will cost 20 million dollars in two years. Assume the interest rate is 10%. If the benefit-cost ratio is greater than 1, the project should be allowed. What is your policy suggestion? Ans: Benefit stream is $14,000,000 + 5M/1.11 + 1M/1.12 = 19,371,900. Cost stream is 20M/1.12 = 16528925.62. Therefore, B/C >1 (benefits outweigh costs) Project should be funded.

2. If the interest rate is 5 percent, what is the present value of $5,000 five years from now? Ans: PV = 5,000/(1.05)5 = 3,917.63 3. What is the interest rate that should be used to ensure a total balance of $3,000 two years from now if you have a starting balance of $2,000? Ans: 2000(1+r)2 = 3000; solve for r and the rate should be 22.4744%. 4. Consider two projects. The first project pays benefits of $90 today and nothing else. The second project pays nothing today, nothing one year from now, but $100 two years from now. Which project would be preferred if the discount rate were 0%? What if the rate increased to 10%? Ans: For a discount rate of 0%, the present value calculations would be $90 for project one and $100 for project two; therefore, project two is preferred. At a rate of 10%, the PV of project one is still $90. For project two, the PV is now 82.6; therefore, project one is preferred

5. Suppose you are planning to take a vacation to bike across the US. Someone is willing to sell you a new bike for $500. At the end of the year, you expect to resell the bicycle for $350. The benefit of using the bicycle is valued at $170. A. Determine the internal rate of return for this scenario assuming that the benefits of the vacation are immediate. The internal rate of return is the discount rate that would make the projects net present value (NPV) equal zero. To solve for the internal rate of return, r, set the present value of benefits minus the present value of costs equal to zero. If we assume the benefit of using the bicycle is immediate (and worth $170), there is also the benefit of re-selling the bicycle for $350, but it cant be re-sold until next year, so must be discounted. Therefore, NPV is 170 + [350/(1+r)] 500 = 0. Solving this expression for r yields r = 6 percent. B. Determine the internal rate of return for this scenario assuming that the benefits of the vacation dont occur until the end of the next year. If we assume that the benefits of the vacation will not be enjoyed for one year, then NPV is [(170+350)/(1+r)] 500 and setting this expression equal to zero and solving for r yields r = 4 percent. C. If the discount rate is 5% should you buy the bicycle? Explain your answer. If the discount rate is 5 percent, purchasing the bicycle is a good idea if iror is 6 percent, but a bad idea if iror is 4 percent.

6. Bill rides the subway at a cost of $0.75 per trip, but he would switch to other transportation if the price were any higher. His only alternative to the subway is a bus that takes him five minutes longer but only costs $0.50. Bill makes 10 trips per year. The city is considering renovations of the subway system that would reduce the trip by 10 minutes but fares would increase by $0.40 per trip to cover the costs. The fare increase and reduced travel time both take effect in one year and last forever. The interest rate is 25%. A. As far as Bill is concerned, what are the present values of the projects benefits and costs? Show your work.

Bill is willing to pay 25 cents to save 5 minutes, so he values time at 5 cents per minute. The subway saves him 10 minutes per trip, or 50 cents. The value of 10 trips per year is $5. The cost of each trip is 40 cents, or $4 per year. The annual net benefit to Bill is therefore $1. The present value of the benefits = $5/.25 = $20; the present value of the costs is $4/.25 = $16 (remember use R/r for benefits and costs that accrue forever!) B. Assume the citys population consists of 55,000 middle-class people, all of whom are identical to Bill and 5,000 high income people. The high income citizens do not use public transportation at all. What are the total benefits and costs of the project for the city as a whole? What is the net present value of the project? Total benefits = $20x55,000=$1,100,000. Total costs = $16x55,000 = $880,000. Net benefits = $220,000. 7. If the demand curve for avocados can be characterized by the equation P = 10 0.5 Q, how much increase in consumer surplus will occur when the price of avocados falls from $2.89 to $1.35? Show this graphically (hint, you must determine the quantity demanded at each price) The original consumer surplus with 2.89 price is (1/2)*(7.11)*(14.22) = 50.55. The new consumer surplus with 1.35 price is (1/2)*(8.65)*(17.3) = 74.83. Consumer surplus increases by 74.83 50.55 = 24.27

8. In an effort to reduce alcohol consumption, the government is considering a $1 tax on each gallon of liquor sold. Suppose that demand for alcohol is given by Qd=500,000 20,000P and the supply equation is Qs=-5000 + 7500P and Ed=-2.77 and Es=1.04. A. Show the market for alcohol and determine the equilibrium price and quantity prior to the tax. Depending on if you set Qs=Qd or P=P you will get slightly different answers: Qd=Qs: P=$18.36; Q=132, 800 P=P: P=$18; Q=140,000 This means as you do the rest of this problem your answers will vary for CS, PS, TS, tax revenue , etc. The solution here is based on Qd=Qs method as done in class.

B. Determine the value of consumer surplus, producer surplus, and total surplus at this original equilibrium. CS= $440, 896 PS=1,174,616 TS=1,615,512

C. Show the new supply curve with the $1 excise tax and determine the new equilibrium price paid by consumers, the net price received by producers, and the new equilibrium quantity. Increase in price is Es/(Es-Ed) * tax = 0.27 New price is then $18.36+.27= 18.63 New quantity using demand equation is 127, 400

D. Determine the amount of tax revenue generated by the excise tax. Who bears the burden of this tax? Tax revenue= tax * new quantity Tax revenue = $127, 400 Consumers pay $34, 398 Producers pay $93,002 Producers bear the burden (less elastic) E. Determine the new consumer surplus, producer surplus, and total surplus values after the tax. Is society better off or worse off with the tax? Briefly explain. CS new= $405, 657 PS new=$1,080,352 TS new=$1,486,121 Efficiency loss (TS is lower) 9. Suppose that income tax is levied at a flat rate of 5%, but no tax is levied above $50,000 in taxable income. Taxable income is the individuals income minus $10,000; that is everyone receives a $10,000 deduction. What are the marginal and average tax rates for the following three workers? a. A part-time worker with annual income of $9,000. A part-time worker with annual income of $9,000 pays no taxes(zero tax liability) since everyone gets a $10,000 deduction. Her marginal tax rate is 0% and her average tax rate is 0%. b. A retail salesperson with annual income of $45,000. A retail salesperson with annual income of $45,000 has taxable income of $35,000 and pays $1750 in taxes (5 percent of taxable income). As a percentage of income, the average tax rate is 3.89% ($1750 is 3.89% of $45,000). Her marginal tax rate is 5% (1750/34000) c. An advertising executive with annual income of $600,000. An advertising executive with annual income of $600,000 pays $2,500 in taxes since no tax is levied above $50,000 in taxable income. As a percentage of income, the average tax rate is 0.42%. Her marginal tax rate is 0%. (750/555,000 is 0.0001)

d. Is the tax progressive, proportional, or regressive with respect to income? The tax is initially progressive, but because of the cap on taxable income, becomes regressive.

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