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Chapter 12. Income Taxes and Capital Budgeting. Oleh Bambang Kesit. Compute the after-tax net present values of projects. Learning Objective 1. Income Taxes and Capital Budgeting. What is an example of another type of cash flow that must be considered

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income taxes and capital budgeting1
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
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
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.
  • The number of years over which an asset is depreciated for tax purposes is called the recoveryperiod.
depreciation deductions for capital budgeting
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 budgeting1
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
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
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
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.
gains or losses on disposal
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 disposal1
Gains or Losses on Disposal
  • If it is sold for bookvalue, 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

inflation
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
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.

payback model
Payback Model
  • Paybacktime, or paybackperiod, 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
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
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 model1
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 model2
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.

Learning Objective 4
performance evaluation
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
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 ma- ke long-term capital investment decisions and how such decisi-ons can affect the companies’ financial results for years to co-me.Learning Objective 5
long term capital investments
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.