Income Tax and Capital Budgeting Decisions

Income Tax and Capital Budgeting Decisions:

Learning Objectives:

  1. 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 :

  1. Taxable income equals net income as computed for financial reports.
  2. 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)
Tax Effect*
After-Tax Cash Flows
(1) × (2)
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.

You may also be interested in other articles from “capital budgeting decisions” chapter:

  1. Capital Budgeting – Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value – Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method – Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method – Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables

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