Taxation

Concept of Taxation in Capital Budgeting

Assume that a company with a tax rate of 30% is contemplating a training program
that costs $60,000. What impact will this have on the companys taxes? The answer is
$42,000

The after-tax cost of any tax-deductible cash expense can be determined using the
following formula:
After-tax cost (net cash outflow) = (1 -Tax rate) x Tax-deductible cash expense

( 1 - 0.30 ) x $ 60,000 = $ 42,000

Depreciation Tax Shield

Depreciation is not a cash flow. For this reason, depreciation was ignored

However, depreciation does affect the taxes that must be paid and therefore has
an effect on a companys cash flows.

Consider a company with annual cash sales of $500,000 and cash operating expenses
of $310,000. In addition, the company has a depreciable asset on which the
depreciation deduction is $90,000 per year. The tax rate is 30%.
Because depreciation deductions shield revenues from taxation, they are generally
referred to as a depreciation tax shield. The term depreciation tax shield may
convey the impression that there is something underhanded about depreciation
deductionsthat companies are getting some sort of a special tax break

Tax savings from the depreciation tax shield = Tax rate x Depreciation deduction

0.30 x $ 90,000 = $ 27,000 reduction in tax payments

Holland Company owns the mineral rights to land that has a deposit of ore. The
company is uncertain if it should purchase equipment and open a mine on the
property. After careful study, the company assembled the following data.

The ore in the mine would be exhausted after 10 years of mining activity, at which
time the mine would be closed. The equipment would then be sold for its salvage
value. Holland Company uses the straight-line method, assuming no salvage value, to
compute depreciation deductions for tax purposes. The companys after-tax cost of
capital is 12% and its tax rate is 30%.

Should Holland Company purchase the equipment and open a mine on the
property?