How do income tax factors affect investment decisions? This post will answer the question in simple way and demonstrate how it works. Unlike any other capital budgeting analyses that come with some multi-heavy algebra calculation. It is somewhat simple and comes with some easy examples that you can follow easily. Read on…
Income taxes make a difference in many capital budgeting decisions. The project that is attractive on a before-tax basis may have to be rejected on an after-tax basis. Income taxes typically affect both the amount and the timing of cash flows. Since net income, not cash inflows, is subject to tax, after-tax cash inflows are not usually the same as after-tax net income.
Let us define:
Then, before-tax cash inflows (or before-tax cash savings)
= S – E and net income = S – E – d
After-tax cash inflows
= Before-tax cash inflows – Taxes
= (S – E) – (S – E – d)(t)
Rearranging gives the shortcut formula:
After-tax cash inflows = (S–E)(1–t) + (d)(t)
= (S – E – d)(1 – 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 make it easier, let’s construct one simple example.
S = $12,000
E = $10,000
d = $500 per year using the straight-line method
t = 30%
Then After-tax cash inflow:
= ($12,000 – $10,000)(1 ? 0.3) + ($500)(0.3)
= ($2,000)(0.7) + ($500)(0.3)
= $1,400 + $150 = $1,550
Note that a tax shield:
= Tax savings on depreciation = (d)(t)
Since the tax shield is “dt”, the higher the depreciation deduction, the higher the tax savings on depreciation. Therefore, an accelerated depreciation method [such as double-declining balance] produces higher tax savings than the straight-line method. Accelerated methods produce higher present values for the tax savings, which may make a given investment more attractive.
Want to go deeper? Let’s construct onemore example. Read on…
Example: Lie Dharma Putra Inc. estimates that it can save $2,500 a year in cash operating costs for the next 10 years if it buys a special-purpose machine at a cost of $10,000. No salvage value is expected. Assume that the income tax rate is 30 percent and that the after-tax cost of capital [minimum required rate of return] is 10 percent.
After-tax cash savings can be calculated as follows:
Note that depreciation by the straight-line method is $10,000/10 = $1,000 per year. Here before-tax cash savings = (S – E) = $2,500. Thus;
After-tax cash savings:
= (S – E)(1 – t) + (d)(t)
= $2,500(1 – 0.3) + $1,000(0.3)
= $1,750 + $300 = $2,050
To see if this machine should be purchased, the “Net Present Value (NPV)” can be calculated.
= $2,050 T4 (10%, 10 years)
= $2,050 (6.145)
Thus, NPV = PV – I = $12,597.25 – $10,000 = $2,597.25.
Since NPV is positive, the machine should be bought.