b12 income taxes and capital budgeting
Chapter
12
Income Taxes and
Capital Budgeting
Oleh
Bambang Kesit
Learning Objective 1
Compute the after-tax
net
present values of
projects.
Income Taxes and
Capital Budgeting
What is an example of another type of
cash flow that must be considered
when 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:
Depreciation method selected
Recovery period
Discount rate
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
provide a cash inflow from income tax savings.
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?
$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 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?
$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 general
purchasing power of the monetary unit.
The key in capital
budgeting is consistent
treatment of the minimum
desired rate of return and the
predicted cash inflows and outflows.
Watch for Consistency
Such consistency can be achieved by
including an element for inflation in
both the minimum desired rate of
return 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.
ARR
=
Increase in expected
average annual
operating income
÷
Initial
required
investment
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.
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 conflict
between capital budgeting and performance
evaluation is to use a DCF for both
capital-budgeting decisions and
performance 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 make long-term capital investment
decisions and how such decisions can affect the companies’
financial results for years to come.
Long-term Capital
Investments…
are critical to a company’s financial success.
Using a discounted cash-flow method helps
managers make optimal capital budgeting
decisions.
End of Chapter
12
Income Taxes and
Capital Budgeting
Oleh
Bambang Kesit
Learning Objective 1
Compute the after-tax
net
present values of
projects.
Income Taxes and
Capital Budgeting
What is an example of another type of
cash flow that must be considered
when 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:
Depreciation method selected
Recovery period
Discount rate
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
provide a cash inflow from income tax savings.
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?
$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 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?
$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 general
purchasing power of the monetary unit.
The key in capital
budgeting is consistent
treatment of the minimum
desired rate of return and the
predicted cash inflows and outflows.
Watch for Consistency
Such consistency can be achieved by
including an element for inflation in
both the minimum desired rate of
return 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.
ARR
=
Increase in expected
average annual
operating income
÷
Initial
required
investment
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.
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 conflict
between capital budgeting and performance
evaluation is to use a DCF for both
capital-budgeting decisions and
performance 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 make long-term capital investment
decisions and how such decisions can affect the companies’
financial results for years to come.
Long-term Capital
Investments…
are critical to a company’s financial success.
Using a discounted cash-flow method helps
managers make optimal capital budgeting
decisions.
End of Chapter