Income Taxes in Capital Budgeting Decisions Chapter 15

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-2 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

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-3 The Concept of After-Tax Cost Tax deductible expenses decease the company’s net taxable income and reduce the taxes the company must pay. Let’s look at the East and West Companies example. East & West

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-4 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 McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-5 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).

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-6 The Concept of After-Tax Cost cost The following formula shows the after-tax cost of any tax-deductible cash expense: After-tax cost = (1 – Tax rate) × After-tax cost = (1 – Tax rate) × (1 – 0.30) × $40,000 = $28,000 Tax-deductible cash expense

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-7 The Concept of After-Tax Cost cost The following formula shows the after-tax cost of any tax-deductible cash expense: After-tax cost = (1 – Tax rate) × After-tax cost = (1 – Tax rate) × (1 – 0.30) × $40,000 = $28,000 Tax-deductible cash expense benefit The following formula shows the after-tax benefit of any taxable cash receipt: After-tax benefit = (1 – Tax rate) × Taxable Cash receipt

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-8 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 15-9 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? After-tax benefit = (1 – Tax rate) × Taxable Cash receipt After-tax benefit = (1 – 0.30) × $80,000 = $56,000

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Concept of After-Tax Cost

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. Let’s look at an example of a depreciation tax shield.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Depreciation Tax Shield Art and Music Companies are identical except that Art has a $60,000 annual depreciation expense:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Depreciation Tax Shield As a result of the depreciation deduction, Art has less net income than Music. But the difference is not $60,000.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Depreciation Tax Shield Let’s look more closely at the difference in net income. $60,000 × (1 – 0.30) = $42,000 We can compute the difference in net income as follows:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Depreciation Tax Shield The tax savings provided by the depreciation tax shield is determined like this: Depreciation Tax Shield Tax rate Depreciation deduction × = 0.30 × $60,000 = $18,000 Depreciation $60,000 Less: tax savings 18,000 Difference in income $42,000

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Modified Accelerated Cost Recovery System (MACRS) MACRS table of 3 and 5-year assets MACRS table of 3 and 5-year assets

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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) Assumes that all assets enter service halfway through the first year and leave service halfway through the last year (half-year convention).

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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. Let’s calculate MACRS depreciation.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill The Choice of a Depreciation Method We should use the income tax method because we are computing the tax savings from depreciation deductions. O.K. For financial reporting a company may elect to use straight-line, units of output or accelerated depreciation. The US tax code requires MACRS.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Martin Company has an investment opportunity that would involve the following cash flows:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Depreciation expense deducted on Martin’s tax returns.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes The tax savings resulting from the depreciation deductions.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Present value of the depreciation tax shield. Present value of $1 table.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Cash flows other than the tax savings from depreciation 1 minus the tax rate ( ) = 0.70

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Present value of an annuity of $1 table. Here is the present value of the cash flows:

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill Capital Budgeting and Taxes Here is the present value of the cash flows: Present value of $1 table.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill 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%.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw-Hill End of Chapter 15