Income Taxes and Capital Budgeting

Oleh

Bambang Kesit

Chapter 12

Learning Objective 1

Compute the after-tax net

present values of projects.

Income Taxes and Capital Budgeting

What is an example of another type ofcash flow that must be consideredwhen making capital-budgeting decisions?

Income taxes

Marginal Income Tax Rate

• In capital budgeting, the relevant tax rate is the marginal income tax rate.

• This is the tax rate paid on additional amounts of pretax income.

Effects of Depreciation Deductions

• For tax purposes, accelerated depreciation is generally allowed.

• The focus is on the tax reporting rules, not those for public financial reporting.

• The number of years over which an asset is depreciated for tax purposes is called the recovery period.

Depreciation Deductions for Capital Budgeting

• Depreciating a fixed asset creates future tax deductions.

• The present value of this deduction depends directly on its specific yearly effects on future income tax payments.

Depreciation Deductions for Capital Budgeting

The present value is influenced by:

Recovery period

Depreciation method selected

Tax rate

Discount rate

Tax Effect on Cash Inflows from Depreciation Deductions

Depreciation expense is a noncash expense andso is ignored for capital budgeting, except thatit is an expense for tax purposes and so willprovide a cash inflow from income tax savings.

Tax Effect on Cash Inflows from Operations

Assume the following:Cash inflow from operations $60,000Tax rate 40%

What is the after-tax inflow from operations?

$60,000 × (1 – tax rate) = $60,000 × .6 = $36,000

Modified Accelerated Cost Recovery System

• Under U.S. income tax laws, most assets purchased since 1987 are depreciated using the Modified Accelerated Cost Recovery System (MACRS).

• This system specifies a recovery period and an accelerated depreciation schedule for all types of assets.

Learning Objective 2

Explain the after-tax effect on

cash of disposing of assets.

Gains or Losses on Disposal

Suppose a piece equipment purchasedfor $125,000 is sold at the end of year3 after taking three years of straight-linedepreciation.

What is the book value?

$125,000 – (3 × $25,000) = $50,000

Gains or Losses on Disposal

• If it is sold for book value, there is no gain or loss and so there is no tax effect.

• If it is sold for more than $50,000, there is a gain and an additional tax payment.

• If it is sold for less than $50,000, there is a loss and a tax savings.

TAX

Learning Objective 3

Compute the impact of inflation

on a capital-budgeting project.

Inflation

What is inflation?

It is the decline in generalpurchasing power of the monetary unit.

The key in capitalbudgeting is consistenttreatment of the minimumdesired rate of return and thepredicted cash inflows and outflows.

Watch for Consistency

Such consistency can be achieved byincluding an element for inflation inboth the minimum desired rate ofreturn and in the cash-flow predictions.

Learning Objective 3

Use the payback model and the accounting rate-of-return model

and compare them with the NPV model.

Payback Model

• Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from operations, the initial dollars invested in a project.

P= I ÷ O

Payback Model Example

• Assume that $12,000 is spent for a machine with an estimated useful life of 8 years.

• Annual savings of $4,000 in cash outflows are expected from operations.

• What is the payback period?

P = I ÷ O = $12,000 ÷ $4,000 = 3 years

Accounting Rate-of-Return Model

• The accounting rate-of-return (ARR) model expresses a project’s return as the increase in expected average annual operating income divided by the required initial investment.

Initialrequiredinvestment

ARR =Increase in expectedaverage annualoperating income

÷

Accounting Rate-of-Return Model

Assume the following:Investment is $6,075.Useful life is four years.Estimated disposal value is zero.Expected annual cash inflowfrom operations is $2,000.

What is the annual depreciation?

Accounting Rate-of-Return Model

$6,075 ÷ 4 = $1,518.75, rounded to $1,519

What is the ARR?

ARR = ($2,000 – $1,519) ÷ $6,075 = 7.9%

Learning Objective 4

Reconcile the conflict between

using an NPV model for making

a decision and using accounting

income for evaluating the

related performance.

Performance Evaluation

The best way to reconcile any potential conflictbetween capital budgeting and performanceevaluation is to use a DCF for bothcapital-budgeting decisions andperformance evaluation.

Post Audit

• A recent survey showed that most large companies conduct a follow-up evaluation of at least some capital-budgeting decisions, often called a post audit.

• The post audit focuses on actual versus predicted cash flows.

Learning Objective 5

Understand how companies ma- ke long-term capital investment decisions and how such decisi-ons can affect the companies’ financial results for years to co-me.

Long-term Capital Investments…

are critical to a company’s financial success.

Using a discounted cash-flow method helpsmanagers make optimal capital budgetingdecisions.

End of Chapter