# Income Taxes in Capital Budgeting Decisions Appendix 8C

Income Taxes in Capital Budgeting Decisions Appendix 8C PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved. 8C-2 Learning Objective 8-8 (Appendix 8C) Include income taxes in a capital budgeting analysis. 8C-3 Simplifying Assumptions Taxable income equals net income as

computed for financial reports. The tax rate is a flat percentage of taxable income. 8C-4 Concept of After-tax Cost An expenditure net of its tax effect is known as after-tax cost. Here is the equation for determining the after-tax cost of any tax-deductible cash expense: After-tax cost = (net cash outflow) (1 - Tax rate)Tax-deductible cash expense 8C-5 After-tax Cost An Example

Assume a company with a 30% tax rate is contemplating investing in a training program that will cost \$60,000 per year. We can use this equation to determine that the after-tax cost of the training program is \$42,000. After-tax cost = (1 - Tax rate)Tax-deductible cash expense (net cash outflow) \$42,000 = (1 - .30)\$60,000 8C-6 After-tax Cost An Example The answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the training program and with the training program. The after-tax cost of the training program is the same\$42,000.

8C-7 After-tax Cost An Example The amount of net cash inflow realized from a taxable cash receipt after income tax effects have been considered is known as the after-tax benefit. After-tax benefit = (net cash inflow) (1 - Tax rate)Taxable cash receipt 8C-8 Depreciation Tax Shield While depreciation is not a cash flow, it does affect the taxes that must be paid and therefore has an indirect effect on a companys cash flows.

Tax savings from the depreciation = Tax rate Depreciation deduction tax shield 8C-9 Depreciation Tax Shield An Example Assume a company has annual cash sales and cash operating expenses of \$500,000 and \$310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is \$90,000; and a 30% tax rate. Tax savings from the depreciation tax shield \$27,000 = = Tax rate Depreciation deduction .30\$90,000

8C-10 Depreciation Tax Shield An Example Assume a company has annual cash sales and cash operating expenses of \$500,000 and \$310,000, respectively; a depreciable asset, with no salvage value, on which the annual straight-line depreciation expense is \$90,000; and a 30% tax rate. Tax savings from the depreciation tax shield \$27,000 = = Tax rate Depreciation deduction .30\$90,000 The depreciation tax shield is \$27,000.

8C-11 Depreciation Tax Shield An Example The answer can also be determined by calculating the taxable income and income tax for two alternativeswithout the depreciation deduction and with the depreciation deduction. The depreciation tax shield is the same \$27,000. 8C-12 Holland Company An Example Holland Company owns the mineral rights to land that has a deposit of ore. The company is deciding whether to purchase equipment and open a mine on the property. The mine would be depleted and closed in 10 years and the equipment would be sold for its salvage value.

More information is provided on the next slide. 8C-13 Holland Company An Example Cost of equipment Working capital needed Estimated annual cash receipts from ore sales Estimated annual cash expenses for mining ore Cost of road repairs needed in 6 years Salvage value of the equipment in 10 years After-tax cost of capital Tax rate \$ \$ 300,000 75,000

\$ 250,000 \$ 170,000 \$ 40,000 \$ 100,000 12% 30% Should Holland open a mine on the property?

8C-14 Holland Company An Example Step One: Compute the annual net cash receipts from operating the mine. Cash receipts from ore sales Less cash expenses for mining ore Net cash receipts \$ \$ 250,000 170,000 80,000 8C-15 Holland Company An Example Step Two: Identify all relevant cash flows as shown. Holland Company

(1) (2) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs Annual depreciation deductions Salvage value of equipment Release of working capital Net present value Year Now Now 1-10 6 1-10 10 10 Amount

\$ (300,000) \$ (75,000) \$ 80,000 \$ (40,000) \$ 30,000 \$ 100,000 \$ 75,000 8C-16 Holland Company An Example Step Three: Translate the relevant cash flows to after-tax cash flows as shown. (1) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs

Annual depreciation deductions Salvage value of equipment Release of working capital Net present value Year Now Now 1-10 6 1-10 10 10 Holland Company (2) (3) Tax Effect Amount (1)(2) \$ (300,000) 0 \$ (75,000)

0 \$ 80,000 1-.30 \$ (40,000) 1-.30 \$ 30,000 .30 \$ 100,000 1-.30 \$ 75,000 0 (4) After-Tax Cash Flows \$ (300,000) \$ (75,000) \$ 56,000 \$ (28,000) \$ 9,000 \$

70,000 \$ 75,000 8C-17 Holland Company An Example Step Four: Discount all cash flows to their present value as shown. (1) Items and Computations Cost of new equipment Working capital needed Annual net cash receipts Road repairs Annual depreciation deductions Salvage value of equipment Release of working capital Net present value Year Now

Now 1-10 6 1-10 10 10 Holland Company (2) (3) (4) (5) (6) Tax Effect After-Tax Cash Amount (1) (2) Flows 12% Factor Present Value \$ (300,000) 0 \$

(300,000) 1.000 \$ (300,000) \$ (75,000) 0 \$ (75,000) 1.000 (75,000) \$ 80,000 1-.30 \$ 56,000 5.650 316,400 \$ (40,000) 1-.30 \$ (28,000) 0.507 (14,196) \$ 30,000 .30 \$

9,000 5.650 50,850 \$ 100,000 1-.30 \$ 70,000 0.322 22,540 \$ 75,000 0 \$ 75,000 0.322 24,150 \$ 24,744 8C-18 End of Appendix 8C

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