Income Taxes and
Capital Budgeting
Oleh
Bambang Kesit
Learning Objective 1
Compute the after-tax
net
Income Taxes and
Capital Budgeting
What is an example of another type of cash flow that must be considered
when making capital-budgeting decisions?
Marginal Income Tax Rate
• In capital budgeting, the relevant tax rate is the marginal income tax rate.
Effects of
Depreciation Deductions
• For tax purposes, accelerateddepreciation is generally allowed.
• The focus is on the tax reporting rules, not those for public financial reporting.
Depreciation Deductions for
Capital Budgeting
• Depreciating a fixed asset creates future tax deductions.
Depreciation Deductions for
Capital Budgeting
The present value is influenced by:
Recovery period
Depreciation method selected
Tax rate
Tax Effect on Cash Inflows from
Depreciation Deductions
Depreciation expense is a noncash expense and so is ignored for capital budgeting, except that it is an expense for tax purposes and so will
Tax Effect on
Cash Inflows from Operations
Assume the following:
Cash inflow from operations $60,000 Tax rate 40%
What is the after-tax inflow from operations?
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).
Learning Objective 2
Explain the after-tax effect
on
Gains or Losses on Disposal
Suppose a piece equipment purchased for $125,000 is sold at the end of year 3 after taking three years of straight-line depreciation.
What is the book value?
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.
Learning Objective 3
Inflation
What is inflation?
It is the decline in general
purchasing power of the monetary unit. The key in capital
budgeting is consistent
treatment of the minimum
desired rate of return and the
Watch for Consistency
Such consistency can be achieved by including an element for inflation in both the minimum desired rate of
Learning Objective 3
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.
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?
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.
Initial required
investment ARR
=
Increase in expected average annual
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 inflow
from operations is $2,000.
Accounting Rate-of-Return
Model
$6,075 ÷ 4 = $1,518.75, rounded to $1,519 What is the ARR?
Learning Objective 4
Reconcile the conflict between
using an NPV model for making
a decision and using accounting
income for evaluating the
Performance Evaluation
The best way to reconcile any potential conflict between capital budgeting and performance
evaluation is to use a DCF for both capital-budgeting decisions and
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.
Learning Objective 5
Long-term Capital
Investments…
are critical to a company’s financial success.
