Income Taxes in Capital Budgeting Decisions

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Income Taxes in Capital Budgeting Decisions
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Income Taxes and Capital Budgeting

• The effects of income taxes on cash flows must be
  considered in capital budgeting decisions when an
  organization is subject to income taxes.

1040
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The Concept of After-Tax Cost

• Tax deductible expenses decease the companys net
  taxable income and reduce the taxes the company
  must pay.
• Lets look at the East and West Companies example.

East West
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The Concept of After-Tax Cost

• East and West Companies are identical except that
  East has a 40,000 annual cash expense for an
  employee training program.

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The Concept of After-Tax Cost

• East and West Companies are identical except that
  East has a 40,000 annual cash expense for an
  employee training program.

The after-tax cost of the training program is
28,000 (70,000 - 42,000).
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The Concept of After-Tax Cost

• The following formula shows the after-tax cost of
  any tax-deductible cash expense

Tax-deductible cash expense
After-tax cost (1 Tax rate)
(1 0.30) 40,000 28,000
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The Concept of After-Tax Cost

• The following formula shows the after-tax cost of
  any tax-deductible cash expense

Tax-deductible cash expense
After-tax cost (1 Tax rate)
(1 0.30) 40,000 28,000
The following formula shows the after-tax benefit
of any taxable cash receipt
Taxable Cash receipt
After-tax benefit (1 Tax rate)
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The Concept of After-Tax Cost

• North Company receives 80,000 per year from
  subleasing part of its office space. North is
  subject to a 30 tax rate.
• What is the after-tax benefit
• from the sublease?

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The Concept of After-Tax Cost

• North Company receives 80,000 per year from
  subleasing part of its office space. North is
  subject to a 30 tax rate.
• What is the after-tax benefit
• from the sublease?

Taxable Cash receipt
After-tax benefit (1 Tax rate)
After-tax benefit (1 0.30) 80,000
56,000
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The Concept of After-Tax Cost

• South Company can invest in a project that
  would provide cash receipts of 400,000 per year.
  Cash operating expenses would be 280,000 per
  year. The tax rate is 30.
• What is the after-tax benefit (net cash inflow)
  each year from this project?

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The Concept of After-Tax Cost
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Depreciation Tax Shield

• Although depreciation is not a cash flow, it does
  have an impact on the amount of income taxes that
  a company will pay. Depreciation deductions
  shield revenues from taxation and thereby reduce
  tax payments.
• Lets look at an example of a depreciation tax
  shield.

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Depreciation Tax Shield

• Art and Music Companies are identical except that
  Art has a 60,000 annual depreciation expense

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Depreciation Tax Shield
As a result of the depreciation deduction, Art
has less net income than Music. But the
difference is not 60,000.
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Depreciation Tax Shield

• Lets look more closely at the difference in net
  income.

We can compute the difference in net income as
follows
60,000 (1 0.30) 42,000
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Depreciation Tax Shield

• The tax savings provided by the depreciation tax
  shield is determined like this

DepreciationTax Shield

0.30 60,000 18,000
Depreciation 60,000 Less tax
savings 18,000 Difference in income
42,000
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Modified Accelerated Cost Recovery System (MACRS)
MACRS table of 3 and 5-year assets
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Modified Accelerated Cost Recovery System (MACRS)
Assumes that all assets enter service halfway
through the first year and leave service halfway
through the last year (half-year convention).
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Modified Accelerated Cost Recovery System (MACRS)
Changes from accelerated to straight-line in the
year that the straight-line begins to exceed the
accelerated depreciation.
Salvage value is not deducted from asset cost
when using MACRS.
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Modified Accelerated Cost Recovery System (MACRS)

• Mason Company purchased a light truck at a cost
  of 30,000 in March of Year 1. The truck is in
  the MACRS five-year property class and it has a
  salvage value of 2,000.
• Lets calculate MACRS depreciation.

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Modified Accelerated Cost Recovery System (MACRS)

• Mason Company purchased a light truck at a cost
  of 30,000 in March of Year 1. The truck is in
  the MACRS five-year property class and it has a
  salvage value of 2,000.

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Modified Accelerated Cost Recovery System (MACRS)

• Mason Company purchased a light truck at a cost
  of 30,000 in March of Year 1. The truck is in
  the MACRS five-year property class and it has a
  salvage value of 2,000.

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The Choice of a Depreciation Method

• For financial reporting a company may elect to
  use straight-line, units of output or accelerated
  depreciation.
• The US tax code requires MACRS.

Which method do I use for capital budgeting?
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The Choice of a Depreciation Method

• We should use the income tax method because we
  are computing the tax savings from depreciation
  deductions.

• For financial reporting a company may elect to
  use straight-line, units of output or accelerated
  depreciation.
• The US tax code requires MACRS.

O.K.
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Capital Budgeting and Taxes

• Martin Company has an investment opportunity that
  would involve the following cash flows

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Capital Budgeting and Taxes

• The equipment has an estimated useful life of 8
  years.
• For tax purposes the equipment is classified in
  the 5-year MACRS property class.
• Martin has an after-tax cost of capital of 10
  and is subject to a 30 income tax rate.
• Should Martin invest in this project?

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Capital Budgeting and Taxes
Depreciation expense deducted on Martins tax
returns.
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Capital Budgeting and Taxes
The tax savings resulting from the depreciation
deductions.
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Capital Budgeting and Taxes
Present value of 1 table.
Present value of the depreciation tax shield.
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Capital Budgeting and Taxes
Cash flows other than the tax savings from
depreciation
1 minus the tax rate (1 - 0.30) 0.70
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Capital Budgeting and Taxes
Here is the present value of the cash flows
Present value of an annuity of 1 table.
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Capital Budgeting and Taxes
Here is the present value of the cash flows
Present value of 1 table.
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Capital Budgeting and Taxes
The net present value of the cash flows is
Because the net present value of this investment
is greater than zero, we know the actual return
will be more than 10.
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End of Chapter 15