Taxes as Transaction Costs Chapter 3 Taxes as Transaction Costs McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Objectives Compute the tax cost of an income item and the tax savings from a deduction Integrate tax costs and savings into NPV calculations Identify the uncertainties concerning future tax costs and savings Explain why tax minimization may not be the optimal business strategy Explain why bilateral tax planning is important in private market transactions Distinguish between arm’s length and related-party transactions

Taxes as Transaction Cost The objective of business decisions is to maximize the value of the firm The first step in evaluating a business transaction is to quantify cash flows from the transaction Managers want to make decisions that maximize the value of the firm by maximizing positive cash flow or minimizing negative cash flow

Time Value of Money When cash flows from a transaction occur at different times, quantification of net cash flow should take into account the time value of money Time value of money: a dollar received today is worth more than a dollar to be received in a future period

Time Value of Money - Terminology Present value: Value of a dollar today Discount rate: Rate of interest on invested funds for deferral period Net present value (NPV): Sum of present values of cash inflows and outflows from a transaction

Discount Rate = r As r increases, how does present value change? Present value decreases How is r related to risk? The riskier the project, the higher the r Should you always use the same r to evaluate different planning schemes? Only if the different schemes have equal risk

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 I--------xI---------xI----------xI----------xI Time 0 Time 1 Time 2 Time 3 Time 4

Time Value of Money - Terminology 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 Ix--------Ix---------Ix----------Ix----------I Time 0 Time 1 Time 2 Time 3 Time 4

Present Value of Ordinary Annuity Formula for present value of an ordinary annuity Where: Pa = Present value of ordinary annuity r = Interest rate n = Number of periods

Present Value Example At the beginning of your freshman year, your uncle makes the following offer: Receive $20,000 when you graduate after four years, or Receive $15,000 now Present value of $20,000 at a 10% discount rate is $13,660 Should you take your uncle’s offer of $15,000 now? Yes! $15,000 now is worth more than $20,000 in four years

Present Value of Ordinary Annuity Assume your uncle makes the following offer: Receive four $15,000 payments at the end of your freshman through senior year (ordinary annuity), or Receive $46,000 now Present value of the annuity at a 10% discount rate is $47,548 Should you take your uncle’s offer of $46,000 now? No, the annuity has the greater present value

Risk Many classroom examples (like the ones above) assume that all cash flows are equally risky Higher risk projects demand higher expected returns which means a higher discount rate Assume that discount rates stated in all examples reflect the correct risk and that the risk does not change over time

Tax Costs as Cash Flows If a transaction results in an increase in any tax for any period, the increase (tax cost) is a cash outflow If a transaction results in a decrease in any tax for any period, the decrease (tax savings) is a cash inflow

Taxes and Cash Flows If cash inflow is nontaxable, after-tax cash inflow = before-tax cash inflow If cash outflow is nondeductible, after-tax cash outflow = before-tax cash outflow If cash inflow is taxable, after-tax cash inflow = before-tax cash inflow × (1- t) If cash outflow is deductible, after-tax cash outflow = before-tax cash outflow × (1- t) 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 $1,000 in deductible student loan interest What is their after-tax interest cost? Bosco: $1,000 × (1 - .35) = $650 Christie: $1,000 × (1 - .15) = $850

Taxes and Cash Flows - Step By Step Determine before-tax cash inflows and outflows (BTCF) from transaction or activity Determine taxable income and deductions Taxable income may not be equal to cash inflows (e.g. sales of inventory on credit) Deductible expenses may not be equal to cash outflows (e.g. depreciation)

Taxes and Cash Flows - Step By Step Compute tax cost of income and tax savings from deductions Compute net after-tax cash inflows or outflows (ATCF) from transaction or activity Compute NPV of net cash flows using an appropriate discount rate

Taxes and Cash Flows - Step By Step George buys a computer for $3,000 today He expects to earn $4,000 cash revenues in each of the next three years by designing web pages He can deduct the cost of the computer as follows: year 1 $1,000; year 2 $1,500; year 3 $500 He expects to be in a 30% tax bracket for all three years Compute NPV of George’s after-tax cash flows using a 10% discount rate

Taxes and Cash Flows - Step By Step Time 0 Year 1 Year 2 Year 3 BTCF (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

Taxes and Cash Flows - Other Issues Several tax-related uncertainties add complexity to the tax planning process Audit risk Tax law uncertainty Marginal rate uncertainty

Audit Risk If the tax law is unclear as to the correct treatment of a transaction, the IRS may challenge the taxpayer’s treatment upon audit The taxpayer may owe additional tax, interest, and possibly penalties The taxpayer’s cost of litigation can be substantial Managers can reduce audit risk by engaging a tax professional or requesting a private letter ruling from the IRS

Tax Law Uncertainty The tax law may change during the time period of the NPV computation For example, capital gains rates change on a frequent basis

Quiz! Which type of tax law provision should be more stable and less uncertain as to its future application? a. A provision relating to the proper measurement of taxable income b. A provision designed to encourage taxpayers to engage in certain economic behavior Answer: a

Marginal Rate Uncertainty The taxpayer may not be able to accurately forecast his future situation Actual marginal tax rate for future years may vary from the projected rate

Structuring Transactions Tax consequences of business transactions depend on the legal and financial structure of the transaction. Firms can change tax consequences by changing the legal or financial structures. However, if a change that saves tax dollars adversely affects other non-tax factors, the change may be a bad idea!

Structuring Transactions The extent to which managers can control the tax consequence of transactions depends on the nature of the market in with the transaction occurs Private market Public market Fictional market between related parties

Structuring Transactions Private market Both parties can customize the transaction to minimize the aggregate tax cost. Tax savings can be shared between the parties Examples: Executive and employer Merger target and acquirer

Structuring Transactions Public market The parties do not engage in direct negotiation Tax planning is one-sided Example: Your first job

Structuring Transactions Fictional market between related parties If related parties are not dealing at arms length, no true market exists and any transaction between them may not reflect economic reality The IRS may disallow any favorable tax treatment