Income Tax and Capital Budgeting Decisions:
Learning Objectives:
-
Include income taxes in a
capital budgeting analysis.
In our discussion of capital budgeting
decisions in this chapter, we ignored income taxes for two
reasons. First, many organizations do not pay income taxes. Not-for-profit
organizations, such as hospitals and charitable foundations, and government
agencies are exempt from income taxes. Second, capital budgeting is complex
and is best absorbed in small doses.
The US income tax code is enormously
complex. We only scratch the surface on this page. To keep the subject
within reasonable bounds, we have made many simplifying assumptions about
the tax code throughout this section. Among the most important of these
assumptions are :
- Taxable income equals net income as
computed for financial reports.
- The tax rate is flat percentage of
taxable income. The actual tax code is for more complex than this; indeed,
experts acknowledge that no one person knows or can know it all. However,
the simplifications that we make throughout this section allow us to cover
the most important implications of income taxes for capital budgeting
without getting bogged down in details
The Concept of After-Tax Cost:
Business, like individuals, must pay income
taxes. In the case of business, the amount of income tax that must be paid
is determined by the company's net taxable income. Tax deductible expenses
(tax deductions) decrease the company's net taxable income and hence reduce
the taxes the company must pay. For this reason, expenses are often stated
on an after-tax basis. For example, if a company pays rent of $10 million a
year but this expense results in a reduction in income taxes of $3 million,
the after-tax cost
of the rent is $7 million. An expenditure net of its tax effect is known as
after-tax cost.
To illustrate, assume that a company with a
tax rate of 30% is contemplating a training program that costs $60,000. What
impact will this have on the company's taxes? To keep matters simple, let's
suppose the training program has no immediate effect on sales. How much does
the company actually pay for the training program after taking into account
the impact of this expense on tax? The answer is
$42,000 as shown below:
The Computation of After-Tax Cost
| |
Without Training Program |
With Training Program |
|
Sales |
$850,000 |
$850,000 |
|
Less tax deductible expense: |
|
|
|
Salaries, insurance, and
other |
700,000 |
7,00,000 |
|
New training program |
|
60,000 |
| |
|
|
|
Total expenses |
7,00,000 |
7,60,000 |
| |
|
|
|
Taxable income |
$150,000 |
$90,000 |
| |
=========== |
============ |
|
Income tax (30%) |
$45,000 |
$27,000 |
| |
=========== |
=========== |
| |
|
|
|
Cost of new training program |
$60,000 |
|
Less: Reduction in income taxes
($45,000 - $27,000) |
18,000 |
| |
|
|
After tax cost of the new training program |
$42,000 |
| |
============== |
While the training program costs
$60,000 before taxes, it would reduce the
company's taxes by $18,000, so its after-tax
cost would be only $42,000
Formula of After-Tax Cost
The after-tax cost of any
deductible cash expense can be determined using the following formula:
|
(1):
After-tax cost (net cash outflow) = (1 -
Tax rate) × Tax-deductible cash expense |
We can verify the accuracy of this formula
by applying it to the $60,000 training program expenditure:
(1 - 0.30) × $60,000 =
$42,000 after-tax cost of the training program
This formula is very useful since it
provides the actual amount of cash a company must pay after taking into
consideration tax effects. It is this actual, after tax, cash outflow that
should be used in capital budgeting decisions.
Similar reasoning applies to revenues and
other taxable cash inflows. Since these cash receipts are taxable, the
company must pay out a portion of them in taxes. The after tax benefit, or
net cash inflow, realized from a particular cash receipt can be obtained by
applying a simple variation of the cash expenditure formula used above:
|
(2):
After-tax benefit (net cash inflow) = (1 - Tax
rate) × Taxable cash receipt
|
We emphasize the term taxable cash receipts
because not all cash inflow are taxable. For example, the release of working
capital at the termination of an investment project would not be a taxable
cash inflow. It is not counted as income for either
financial
accounting or income tax reporting purposes since it is simply a
recovery of the initial investment.
Depreciation Tax Shield:
Depreciation is not a cash flow. For this
reason, depreciation was ignored (in
capital budgeting decisions chapter) in all discounted cash flow
computations. However depreciation does affect the taxes that must be paid
and therefore has an indirect effect on the company's cash flows.
To illustrate the effect of depreciation
deductions on tax payments, consider a company with annual cash sales of
$500,000 and cash operating expenses of $310,000. In addition, the company
has a depreciable asset on which the depreciation deduction is $90,000 per
year. The tax rate is 30%. As shown below the depreciation deduction reduces
the company's taxes by $27,000.
The Impact of Depreciation Deduction on Tax Payment
| |
Without Depreciation Deduction |
With Depreciation Deduction |
|
Sales |
$500,000 |
$500,000 |
|
Cash operating expenses |
310,000 |
310,000 |
| |
|
|
|
Cash flows from operations |
190,000 |
190,000 |
|
Depreciation expenses |
-- |
90,000 |
| |
|
|
|
Taxable income |
$190,000 |
$100,000 |
| |
=========== |
=========== |
|
Taxable income |
$150,000 |
$90,000 |
| |
=========== |
============ |
|
Income tax (30%) |
$57,000 |
$30,000 |
| |
=========== |
=========== |
| |
$27,000 lower taxes with
the depreciation deduction |
| |
|
|
|
Cash flow comparison: |
|
|
|
Cash flow from operations (above) |
$190,000 |
$190,000 |
|
Income taxes
(above) |
57,000 |
30,000 |
| |
|
|
|
Net cash flow |
$133,000 |
$160,000 |
| |
========= |
========= |
|
$27,000 greater cash flow
with the depreciation deduction |
In effect, the depreciation deduction of
$90,000 shields $90,000 in revenues from taxation and thereby reduces the
amount of taxes that the company must pay. Because depreciation deductions
shield revenues from taxation, they generally referred to as a
depreciation tax shield. The reduction in the tax payments made possible
by depreciation tax
shield is equal to the amount of the depreciation deduction, multiplied
by the tax rate as follows:
|
(3): Tax savings from the depreciation tax
shield = Tax rate × Depreciation deduction |
We can verify this formula
by applying it to the $90,000 depreciation deduction in our example:
0.30
×
$90,000 = $27,000 reduction in tax payments
On this page, when we estimate after-tax
cash flows for capital budgeting decisions, we will include the tax savings
provided by the
depreciation tax shield. To keep matters simple, we will assume that
depreciation reported for tax purposes is straight line depreciation, with
no deduction for zero salvage. In other words, we will assume that the
entire original cost of the asset is written evenly over its useful life.
Since the net book value of the asset at the end of its useful life will be
zero under this depreciation method, we will assume that any proceeds
received on disposal of the asset at the end of its useful life will be
taxed as ordinary income.
In actuality the rules are more complex
than this and most companies take advantage of accelerated depreciation
methods allowed by the tax code. These accelerated methods usually result in
reduction in current taxes and an offsetting increase in future taxes. This
shifting of the part of the tax burden from the current year to future years
is advantageous from a present value point of view, since a dollar today is
worth more than a dollar in future. A summary of the concepts we have
introduced so far is given below:
|
Item |
Treatment |
| Tax-deductible
cash expense |
Multiply by (1
- tax rate) to get after tax cost |
| Tax cash
receipt |
Multiply by (1
- tax rate) to get after tax cash inflow. |
| Depreciation
deduction |
Multiply by the
tax rate to get the tax salvage from the depreciation tax shield. |
| |
|
Cash expenses can be deducted from the cash receipts and the difference
multiplied by (1 - tax rate). See the example at the end of this page. |
Example of Income Taxes and Capital Budgeting:
Armed with an understanding of after-tax
cost, after-tax revenue, and the depreciation tax shield, we are now
prepared to examine a comprehensive example of income taxes and capital
budgeting.
Holland Company owns the
mineral rights to land that has a deposit of ore. The company is uncertain
as to whether it should purchase equipment and open a mine on the property.
After careful study, the following data have been assembled by the company:
Should Holland Company
purchase the equipment and open a mine on the property? The solution to the
problem is given below:
|
Cash receipt from sale of ore |
|
$250,000 |
|
|
Less payments for salaries, insurance, utilities, and other cash
expenses |
170,000 |
|
| |
|
|
|
|
Net cash receipts |
|
$80,000 |
|
| |
|
====== |
|
|
Items and Computations |
Year(s) |
(1)
Amount |
(2)
Tax Effect* |
After-Tax Cash Flows
(1) × (2) |
12%
Factor |
Present Value of Cash Flows |
| Cost of new
equipment |
Now |
$(300,000) |
- |
$(300,000) |
1.000 |
$(300,000) |
| Working
capital needed |
Now |
(75,000) |
- |
(75,000) |
1.000 |
(75,000) |
| Net annual
cash receipts (above) |
1-10 |
80,000 |
1-0.30 |
56,000 |
5.650 |
316,400 |
| Road repairs |
6 |
(40,000) |
1-0.30 |
(28,000) |
0.507 |
(14,196) |
| Annual
depreciation deduction |
1-10 |
30,000 |
0.30 |
9,000 |
5.650 |
50,850 |
| Salvage value
of equipment |
10 |
100,000 |
1-0.30 |
70,000 |
0.322 |
22,540 |
| Release of
working capital |
10 |
75,000 |
- |
75,000 |
0.322 |
24,150 |
| |
|
|
|
|
|
|
| Net present
value |
|
|
|
|
|
$24,744 |
| |
|
|
|
|
|
====== |
|
* Taxable cash receipts and deductible cash
expenses are multiplied by (1 - Tax rate) to determine the after-tax
cash flow. Depreciation deductions are multiplied by the tax rate itself
to determine the after-tax cash flow (i.e., tax savings from the
depreciation tax shield). |
We suggest that you go
through this solution item by item and note the following points:
Cost of new equipment:
The initial investment of $300,000 in the
new equipment is included in full with no reduction for taxes. This
represents an investment, not an expense, so no tax adjustment is made.
(Only revenue and expenses are adjusted for the effects of taxes.) However,
this investment does affect taxes through the depreciation deduction that
are considered below.
Working Capital:
Observe that the working capital needed for
the project is included in full with no reduction for taxes. Like the cost
of new equipment, working capital is an investment and no expense so no tax
adjustment is made. Also observe that no tax adjustment is made when the
working capital is released at the end of the project's life. The release of
working capital is not a taxable cash flow, since it merely represents a
return of investment funds back to the company.
Net Annual Cash Receipts:
The net annual cash receipts from sales of
ore are adjusted for the effects of income taxes, as discounted earlier. Not
from the above example that annual cash expenses are deducted from the
annual cash receipts to obtain the net cash receipts. This just simplifies
computations.
Road Repairs:
Since the road repairs occur once (in the
sixth year), they are treated separately from other expenses. Road repairs
would be a tax deductible cash expense, and therefore they are adjusted for
the effects of income taxes, as discussed earlier.
Depreciation Deductions:
The equipment is the MACRS seven-year
property class. The tax savings provided by depreciation deductions is
essentially an annuity that is included in the present value computations in
the same way as other cash flows.
Salvage Value of the Equipment:
Since the company does not consider salvage
value when computing depreciation deductions, book value will be zero at the
end of the life of an asset. Thus, any salvage value received is taxable as
income to the company. The
after-tax benefit
is determined by multiplying the salvage value by (1 - Tax rate).
Since the net present value of the proposed
project is positive, the equipment should be purchased and the mine opened.
|
