### Accounting

# Effect of Income Taxes on Capital Budgeting Decisions

**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.

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Let us define:

**S** = Sales

**E** = Cash operating expenses

**d** = Depreciation

**t** = Tax rate

Then, **before-tax cash inflows** (**or before-tax cash savings**)

**= S – E and net income = S – E – d**

By definition;

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)

or;

**= (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.

Example:

*** Assume**:

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)

= ($500)(0.3)

= $150

**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.

**PV**:

= $2,050 T4 (10%, 10 years)

= $2,050 (6.145)

= $12,597.25

Thus, **NPV = PV **–** I** = $12,597.25 – $10,000 = $2,597.25.

**Since NPV is positive, the machine should be bought**.