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Effect of Income Taxes on Capital Budgeting Decisions

1 comment - Leave comment Topics:Accounting, Budgeting, Capital Budgeting, Corporate Income Tax, Tax Accounting, Tax trategies, Taxation Facebook Twitter Google+ How do income tax factors affect investment decisions? This post will answer the question in simple way and demonstrate how it works ! "nli#e an$ ot%er capital &udgeting anal$ses t%at come 'it% some multi-%eav$ alge&ra calculation! It is some'%at simple and comes 'it% some eas$ examples t%at $ou can follo' easil$! (ead on) ncome taxes make a difference in many capital budgeting decisions! The pro"ect that is attractive on a before#tax basis may have to be re"ected on an after#tax basis! Income taxes t$picall$ affect &ot% t%e amount and t%e timing of cas% flo's! ince net income, not cas% inflo's, is su&*ect to tax, after-tax cas% inflo's are not usuall$ t%e same as after-tax net income! Let us define: $ + ales % + Cas% operating expenses d + Depreciation t + Tax rate T%en, before#tax cash inflows ,or before#tax cash savings& $ ' % and net income & $ ' % ' d By definition; After-tax cash inflows = Before-tax cash inflows - Taxes = (S - E) - (S - E - d)(t)

(earranging gives the shortcut formula: )fter#tax cash inflows + , .E-,1.t- / ,d-,tor0 & *$ # % # d+*, # t+ + *d+ Note: The deductibility of depreciation from sales in arriving at net income subject to taxes reduces income tax payments and thus serves as a tax shield.

Tax shield & Tax savings on depreciation & *d+*t+ To ma#e it easier, let1s construct one simple example! Example: - )ssume: + 213,444 E + 214,444 d + 2544 per $ear using t%e straig%t-line met%od t + 647 Then )fter#tax cash inflow: + ,213,444 - 214,444-,1 8 4!6- / ,2544-,4!6+ ,23,444-,4!9- / ,2544-,4!6+ 21,:44 / 2154 + 21,554 .ote that a tax shield: + Tax savings on depreciation + ,d-,t+ ,2544-,4!6+ 2154 $ince the tax shield is ;dt<, the higher the depreciation deduction/ the higher the tax savings on depreciation! T%erefore, an accelerated depreciation method =suc% as dou&le-declining &alance>produces higher tax savings than the straight#line method! )ccelerated methods produce higher present values for the tax savings/ which may make a given investment more attractive! 0ant to go deeper? Let1s construct onemore example! (ead on) %xample: Lie D%arma ?utra Inc! estimates t%at it can save 23,544 a $ear in cas% operating costs for t%e next 14 $ears if it &u$s a special-purpose mac%ine at a cost of 214,444! .o salvage value is expected! )ssume that the income tax rate is 12 percent and that the after#tax cost of capital=minimum re@uired rate of return> is ,2 percent! )fter#tax cash savings can be calculated as follows: Aote t%at depreciation &$ t%e straig%t-line met%od is 214,444B14 + 21,444 per $ear! Here before#tax cash savings & *$ # %+ & 34/522! T%us0 )fter#tax cash savings: + , - E-,1 - t- / ,d-,t+ 23,544,1 - 4!6- / 21,444,4!6+ 21,954 / 2644 + 23,454 To see if this machine should be purchased , t%e ;.et 6resent 7alue *.67+; can &e calculated! 67: + 23,454 T: ,147, 14 $ears-

+ 23,454 ,C!1:5+ 213,5D9!35 T%us, .67 & 67 -

+ 213,5D9!35 - 214,444 + 23,5D9!35!