Chapter 3 Taxes as Transaction Costs McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Taxes as Transaction Costs Chapter 3

Objectives Compute tax costs of income and tax savings from deductions. Compute net present value of after-tax cash flows. Identify sources of tax uncertainty. Maximize after-tax values versus minimize taxes. Tax planning in private market transactions. Distinguish arm’s length from related-party transactions.

Taxes as Transaction Cost Goal - MAXIMIZE AFTER-TAX values, NOT MINIMIZE TAXES

Time Value of Money Terminology Present Value Example Present Value of an Annuity Example

Time Value of Money - Terminology Time Value of Money: a dollar today is worth more than a dollar to be received in some future period. Present value: the value of a dollar today. Discount Rate the rate of interest on invested funds for the deferral period. As r increases, what does the present value do? How is r related to risk? Should you always use the same r to evaluate 2 different planning schemes? Net Present Value: the sum of the present values of cash inflows and outflows relating to a transaction.

Present Value Formula Present value formula Where : PV($1) = Present value of one dollar today r = Interest Rate n = Number of Periods

Time Value of Money - Terminology Present Value of an Ordinary Annuity The value today of a series of constant dollar payments available at the END of each period for a specific number of periods. Present Value of an Annuity Due The value today of a series of constant dollar payments available at the BEGINNING of each period for a specific number of periods.

Present Value of an Ordinary Annuity Formula for the Present Value of an Ordinary Annuity Where: Pa = Present value of Ordinary Annuity r = Interest Rate n = Number of Periods

Present Value Example Present Value example Assume that at the beginning of your freshman year your great Uncle makes the following offer Receive $20,000 on your graduation day 4 years hence, or Receive $15,000 now. Discount rate 10% The present value of the $20,000 using a 10 percent discount rate is $13,660. Thus, should you take your Uncle’s offer of $15,000 today?

Present Value of an Ordinary Annuity Assume your Uncle feels particularly generous and makes the following offer: Receive 4 payments of $15,000 at the end of your freshman through senior year, or Receive $46,000 now The first option is an example of an ordinary annuity. Using a 10 percent annual interest rate for 4 periods) the present value of the annuity is $47,548.

Risk Many classroom examples (like the ones above) assume that all cash flows are equally risky. Higher risk projects demand higher expected returns = higher discount rate. Assume that discount rates stated in examples already reflect the relative risk of the transaction, and that the risk does not change over time.

Taxes and Cash Flows If cash flow is nontaxable, after-tax cash flow = pretax cash flow. If cash expense is nondeductible, after-tax cash cost = pretax cash cost. If cash flow is taxable, after-tax cash flow = pretax cash flow x (1-t). If cash expense is deductible, after-tax cash cost = pretax cash cost x (1-t). where t = marginal tax rate

Relation Between Taxes and Cash Flows Does the after-tax cost of a deductible expense increase or decrease as the taxpayer’s marginal income tax rate increases? Example: Bosco is in the 35% bracket. Christie is in the 15% bracket. Each taxpayer pays $1000 in deductible student loan interest. What is their after tax interest costs, respectively?

Taxes and Cash Flows However, taxable income need NOT equal pre-tax cash flows. Examples: Sales of inventory on credit Depreciation expense

Relation Between Taxes and Cash Flows - Step By Step 1) determine yearly PRE-TAX cash inflows and outflows. 2) determine yearly TAXABLE income and deductions. Taxable income may not be equal to cash inflows. Deductible expenses may not be equal to cash outflows (e.g. depreciation). 3) compute yearly cash outflows to pay TAX on taxable income and cash inflow from tax deductions = -( 2) x MTR) 4) Compute yearly net AFTER-TAX cash inflows or outflows. 1) + 3) 5) Compute NPV of yearly net cash flows.

Relation Between Taxes and Cash Flows - Step By Step George buys a computer for $3000 at time zero. He expects to earn $4000 in cash revenues each of the next three years designing web pages. For tax purposes, he can deduct the cost of the computer as follows: year 1: $1000, year 2: $1500, year 3: 500. He expects to be in a 30% tax bracket for all three years. Assume a discount rate of 10%. What is the net present value of his after-tax cash flows?

Relation Between Taxes and Cash Flows - Step By Step Use steps 1 - 5 Time 0 Year 1 Year 2 Year 3 CASH (3,000) 4,000 TAXABLE 3,000 2,500 3,500 TAX (900) (750) (1,050) ATCF 3,100 3,250 2,950 PV 2,818 2,686 2,216 NPV 4,720

Relation Between Taxes and Cash Flows - Other Issues The marginal tax rate that applies (Step 3) may differ by type of income. See AP 2, 3. Most of the problems and examples in the text assume that payments occur at the BEGINNING of the year.

Tax Uncertainty Audit risk - the tax law may be unclear - risk that the IRS may disagree with taxpayer treatment. Possible interest plus penalties plus tax. Tax law uncertainty - the tax law may change. For example, the capital gains rates and holding periods have changed frequently. See Q7, 8. Marginal rate uncertainty - the taxpayer may not be able to predict annual income and tax position at the time transaction happens. See Q10, IR1.

Structuring Transactions Private market - both parties can customize the transaction. Examples: executive and employer, merger target and acquirer. See IR8, TPC1. Public market - without direct negotiation, tax planning is one-sided. Example: your first job. Related party markets - extreme tax avoidance may create suspicion of tax evasion. Q12.