I n assessing a company’s current and future cash flows, the financial

I n assessing a company’s current and future cash flows, the financial

analyst requires information concerning a company’s tax obligations. Unfortunately, the company’s tax return is not publicly available, requiring the analyst to understand the basics of corporate taxation and to work with information disclosed in the financial statements.

The tax laws are changed almost constantly and are likely being changed as you read this chapter. Hence, no purpose would be served by covering all the details of present tax laws; they might be outdated as soon as you learn them. Instead, we discuss some of the principles behind the tax laws and in doing so provide an opportunity for you to learn some terminology, do some basic taxation calculations, and see how taxes affect a company’s cash flows. We use the rates in the 2001 tax laws for demonstration purposes.

Following are the main kinds of taxes: ■ Income taxes are taxes specifically levied on the basis of income.

■ Employment taxes are also based on income, but specifically on wage and salary income. In the United States, employment taxes are paid by the employee and the employer, and they are designated spe- cifically for social insurance programs (i.e., retirement and unem- ployment).

■ Excise taxes are taxes on certain commodities, such as alcoholic beverages, tobacco products, telephone service, and gasoline. Excise taxes provide an easy way of raising revenue, and they can be imposed to discourage the use of specific products, such as tobacco.

■ Import and export taxes (or tariffs) are taxes based on trade with other countries and are imposed to achieve specific economic goals in world trade.

FOUNDATIONS

In this chapter, we focus on income taxes and, specifically, U.S. fed- eral corporate income taxes. However, any of the other types of taxes may have a strong influence on the cash flows of industries or firms. For example, excise taxes and import and export taxes will influence the demand for a firm’s products and therefore the firm’s cash flows.

THE U.S. TAX LAW In the United States, the federal tax law is the product of all three

branches of federal government. Congress passes the tax legislation that comprises the Internal Revenue Code (IRC). The Internal Revenue Ser- vice (IRS), a part of the Treasury Department, interprets these laws, adds the details, and implements them. The IRS does this by providing and processing tax forms, collecting tax payments, explaining the law in its regulations, and even providing decisions regarding the law (called rulings) in some situations. The courts are also called on to interpret the law through specific court cases, and there is now a well-developed case law related to the IRC. Together the Internal Revenue Code, IRS regula- tions, IRS rulings, and the case law make up federal tax law.

In forecasting future cash flows, the financial analyst needs to be aware that tax rates change frequently. The financial analyst cannot simply assume that the tax rate in existence today will be the same in five or ten years. Moreover, in comparing the after-tax performance of a firm over time, changes in tax rates must be considered.

U.S. FEDERAL TAX RATES Exhibit 5.1 shows the 2001 U.S. federal income tax rate schedules for cor-

porations. We can look at the schedule for a corporation to see how the income tax is computed. Each line of the schedule represents a layer of tax- able income, sometimes called a “tax bracket”; the lower limit of each bracket is called its base. So the first line, for example, represents the tax- able income layer with base $0 and maximum taxable income of $50,000.

Each line of the schedule also tells us the dollar amount of the tax on the base and the rate at which income above the base is taxed in that bracket. Suppose a corporation has taxable income of $12 million. Using the tax rate schedule, we see that the tax is 15% on the first $50,000, 25% on the next $25,000, 34% on the next $25,000, 39% on the next $235,000, 34% on the next $9,665,000, and 35% on the last $2,000,000, or:

Taxation

EXHIBIT 5.1 Federal Income Tax Rate Schedule for Corporations, 2001

If taxable income is: over …

but not over …

tax is …

of the amount over …

Tax on $12,000,000 = $3,400,000 + ( 0.35 $12,000,000 10,000,000 – ) = $3,400,000 + 700,000 = $4,100,000

The marginal tax rate is the rate at which the next dollar of income would be taxes. It is the rate that defines the tax bracket. For a corpora- tion with income falling between $50,000 and $75,000, the marginal tax rate in 2001 is 25%; for a corporation with income between $10 million and $15 million, the marginal tax rate is 35%.

The average tax rate is the ratio of the tax paid on the taxable income. So, for example, the corporation with $12 million in taxable income paid an average tax rate of:

Average tax rate on $12,000,000 = --------------------------------- = 0.3417 or 34.17%

Note that this average tax rate is lower than the marginal tax rate, 35%. This is true for all progressive taxes, such as the U.S. federal income tax. A progressive tax is one that levies a higher average tax rate on higher incomes.

The marginal and average tax rates for a range of 2001 taxable cor- porate incomes are graphed in Exhibit 5.2. It is apparent from this dia- gram that as corporate incomes increase, the average rate approaches the marginal rate of tax. It is also apparent that the corporate income tax is progressive. Note, however, that the corporate tax rate schedule in 2001 has a “bubble” of 39% in the $100,000 to $335,000 bracket, where the rate is lower in the next higher tax bracket. These bubbles appear occasionally in the tax rate schedules mainly to increase reve-

FOUNDATIONS

nues, and many times they disappear from the schedules after a year or two. They usually do not change the progressive nature of the tax.

It is important to realize that taxable income is taxed at the appro- priate marginal rate for each bracket, and not at the average rate. Therefore, when a company’s investment or financing decision is likely to affect taxable income—and hence cash flow—it will do so through the marginal income tax rate.