income taxes in capital budgeting decisions chapter 15

Income Taxes in Capital Budgeting Decisions

Chapter

15

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

10401040


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


15-4


East and West Companies are identical except that East has a $40,000 annual cash expense for an

employee training program.East

CompanyWest

Company

Sales 250,000$ 250,000$ Less expenses: Salaries, insurance, etc. 150,000 150,000 Training program 40,000 - Total expenses 190,000 150,000 Income before taxes 60,000 100,000 Less: income taxes (30%) 18,000 30,000 Net income 42,000$ 70,000$


15-5


East and West Companies are identical except that East has a $40,000 annual cash expense for an

employee training program.East

CompanyWest

Company

Sales 250,000$ 250,000$ Less expenses: Salaries, insurance, etc. 150,000 150,000 Training program 40,000 - Total expenses 190,000 150,000 Income before taxes 60,000 100,000 Less: income taxes (30%) 18,000 30,000 Net income 42,000$ 70,000$

The after-tax cost of the training program is $28,000 ($70,000 -

$42,000).

The after-tax cost of the training program is $28,000 ($70,000 -

$42,000).


15-6


The following formula shows the after-tax costcost 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-deductibleTax-deductiblecash expensecash expense


15-7


The following formula shows the after-tax costcost 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-deductibleTax-deductiblecash expensecash expense

The following formula shows the after-tax benefitbenefit of any taxable cash receipt:

After-tax benefit = (1 – Tax rate) ×After-tax benefit = (1 – Tax rate) × Taxable Taxable Cash receiptCash receipt


15-8


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 What is the after-tax benefit from the sublease?from the sublease?


15-9


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 What is the after-tax benefit from the sublease?from the sublease?

After-tax benefit = (1 – Tax rate) ×After-tax benefit = (1 – Tax rate) × Taxable Taxable Cash receiptCash receipt

After-tax benefit = (1 – 0.30) × $80,000 = $56,000


15-10


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 What is the after-tax benefit (net cash inflow) each year from this project?inflow) each year from this project?


15-11


Annual cash receipts 400,000$ Annual cash operating expenses 280,000 Annual net cash inflow 120,000 Multiply by (100% - 30%) 70%Annual after-tax net cash inflows 84,000$

Annual cash receipts 400,000$ Annual cash operating expenses 280,000 Annual net cash inflow 120,000 Multiply by (100% - 30%) 70%Annual after-tax net cash inflows 84,000$


15-12

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 Let’s look at an example of a depreciation tax shield.depreciation tax shield.


15-13


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

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

Art Company

Music Company

Sales 500,000$ 500,000$ Less expenses: Cash operating expenses 340,000 340,000 Depreciation expense 60,000 - Total expenses 400,000 340,000 Income before taxes 100,000 160,000 Less income taxes (30%) 30,000 48,000 Net income 70,000$ 112,000$

Art Company

Music Company



15-14


As a result of the depreciation deduction, Art has less net income than Music. But the difference is

not $60,000.

As a result of the depreciation deduction, Art has less net income than Music. But the difference is

not $60,000.

Art Company

Music Company


Art Company

Music Company



15-15


Let’s look more closely at the difference in net income.

Net income of Music 112,000$Net income of Art 70,000 Difference in net income 42,000

Net income of Music 112,000$Net income of Art 70,000 Difference in net income 42,000

$60,000 × (1 – 0.30) = $42,000

We can compute the difference in net income as follows:


15-16


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

DepreciationTax Shield

Taxrate

Depreciationdeduction

×=

0.30 × $60,000 = $18,000

Depreciation $60,000Less: tax savings 18,000Difference in income $42,000


15-17

Modified Accelerated Cost Recovery System (MACRS)

Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%

*Change to straight-line

Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%


MACRS table of3 and 5-year assets

MACRS table of3 and 5-year assets


15-18

Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%


Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%



Assumes that all Assumes that all assets enter service assets enter service halfway through the halfway through the first year and leave first year and leave

service halfway service halfway through the last year through the last year

(half-year convention)half-year convention).


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Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%


Year 3-Year 5-Year1 33.3% 20.0%2 44.5% 32.0%3 14.8% * 19.2%4 7.4% 11.5% *5 11.5%6 5.8%

100% 100%



Changes from Changes from accelerated to accelerated to

straight-line in the straight-line in the year that the year that the

straight-line begins straight-line begins to exceed the to exceed the accelerated accelerated

depreciation.depreciation.

Salvage value is not deducted from asset cost when using MACRS.


15-20


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.Let’s calculate MACRS depreciation.


15-21




Year Cost MACRS

% Depr.

Expense1 30,000$ 20.0% 6,000$ 23456


Year Cost MACRS

% Depr.

Expense1 30,000$ 20.0% 6,000$ 23456



15-22




Year Cost MACRS

% Depr.

Expense1 30,000$ 20.0% 6,000$ 2 30,000 32.0% 9,600 3 30,000 19.2% 5,760 4 30,000 11.5% * 3,450 5 30,000 11.5% 3,450 6 30,000 5.8% 1,740

100.0% 30,000$


Year Cost MACRS

% Depr.

Expense1 30,000$ 20.0% 6,000$ 2 30,000 32.0% 9,600 3 30,000 19.2% 5,760 4 30,000 11.5% * 3,450 5 30,000 11.5% 3,450 6 30,000 5.8% 1,740

100.0% 30,000$



15-23

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?


15-24

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.


15-25

Capital Budgeting and Taxes

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

Cost of new equipment 400,000$ Working capital required 80,000 Net annual cash receipts for 8 years 100,000 Equipment repairs in 4 years 40,000 Salvage value of equipment 50,000


15-26


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?Should Martin invest in this project?


15-27


Year Cost MACRS % Depr.1 400,000$ 20.0% 80,000$ 2 400,000 32.0% 128,000 3 400,000 19.2% 76,800 4 400,000 11.5% 46,000 5 400,000 11.5% 46,000 6 400,000 5.8% 23,200

100.0% 400,000$

Year Cost MACRS % Depr.1 400,000$ 20.0% 80,000$ 2 400,000 32.0% 128,000 3 400,000 19.2% 76,800 4 400,000 11.5% 46,000 5 400,000 11.5% 46,000 6 400,000 5.8% 23,200

100.0% 400,000$

Depreciation expense deductedon Martin’s tax returns.


15-28


The tax savings resulting fromthe depreciation deductions.


15-29


YearAfter tax cash flow 10% factor

Present value

1 24,000$ 0.909 21,816$ 2 38,400 0.826 31,718 3 23,040 0.751 17,303 4 13,800 0.683 9,425 5 13,800 0.621 8,570 6 6,960 0.564 3,926

Total 92,758$

Present value of thedepreciation tax shield.

Present value of $1 table.


15-30


Year(s) Amount Tax

effect After tax

cash flowsCost of equipment Now (400,000)$ - (400,000)$Working capital Now (80,000) - (80,000) Cash receipts 1-8 100,000 0.70 70,000 Equipment repairs 4 (40,000) 0.70 (28,000) Salvage value 8 50,000 0.70 35,000 Release of working capital 8 80,000 - 80,000

Cash flows other than the tax savingsfrom depreciation

1 minus the tax rate(1 - 0.30) = 0.70


15-31


Present value of anannuity of $1 table.

Here is the present value of the cash flows:


15-32


Here is the present value of the cash flows:

Present value of $1 table.


15-33


Year(s) Present

Value Cost of equipment Now (400,000)$ Working capital Now (80,000) Annual cash receipts 1-8 373,450 Depreciation 1-6 92,758 Equipment repairs 4 (19,124) Salvage value 8 16,345 Release of working capital 8 37,360 Net Present value 20,789$

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%.Because the net present value of this investment is greater than zero, we know the actual return will be more than 10%.


15-34

End of Chapter 15

income taxes in capital budgeting decisions chapter 15

Documents

tax rate aftertax cost

concept of aftertax

mcgrawhill companies

cost tax deductible

cash flows

cash receipts

annual cash expense

east west slide