Impact of income tax on capital budgeting decisions

The income tax usually have a significant effect on the cash flow of a company and should be taken into account while making capital budgeting decisions. An investment that looks desirable without considering income tax may become unacceptable after considering income tax. Before explaining the impact of income tax on capital budgeting using a net present value example, we need to understand three concepts. These are after-tax benefit, after-tax cost and depreciation tax shield. A brief explanation of each is given below:

After-tax benefit or cash inflow:

Taxable revenues or cash inflows, when reduced by the income tax, are known as after-tax benefit or after-tax cash inflow. When income tax is considered in capital budgeting decisions, after-tax cash inflow is used. An example of taxable cash inflow is cash generated by a company from its operations.

After tax benefit or after tax cash inflow can be easily computed using the following formula:

After-tax benefit or after-tax cash inflow = (1 – Tax rate) × Taxable cash receipt

Example 1:

XYZ company generated $10,000 cash from its operations. The tax rate of the company is 30%. Compute after-tax cash inflow.

Solution:

After-tax benefit or after-tax cash inflow = (1 – Tax rate) × Taxable cash receipt
= (1 – 0.3) × $10,000
= 0.7 × $10,000
= $7,000

After-tax cost:

Tax deductible costs reduce taxable income and help save income tax. A cost net of its tax effect is known as after-tax cost. After-tax cost can be computed using the following formula:

After-tax cost or after tax cash outflow = (1 – Tax rate) × Tax deductible cash expense

Example 2:

A company wants to start a training program that will cost $50,000. The training program is a tax deductible cost for the company. Compute after-tax cost of training program if tax rate of the company is 30%.

Solution:

After-tax cost or after tax cash outflow = (1 – Tax rate) × Tax deductible cash expense
= (1 – 0.3) × $50,000
= 0.7 × $50,000
= $35,000

Depreciation tax shield:

Depreciation is a non-cash tax deductible expense that saves income tax by reducing taxable income. The amount of tax that is saved by depreciation is known as depreciation tax shield. The formula to compute depreciation tax shield is as follows:

Depreciation tax shield = Tax rate × Depreciation deduction

Example 3:

The annual tax deductible depreciation of a company is $25,000 and tax rate is 30%. Compute tax savings from depreciation (depreciation tax shield).

Solution:

Depreciation tax shield = Tax rate × Depreciation deduction
= 0.3 × $25,000
= $7,500

Capital budgeting with income tax:

As the after-tax cash inflow, after-tax cost and depreciation tax shield have been discussed, We can explain the impact of income tax on capital budgeting with the help of a comprehensive example.

Example 4:

A company is considering the purchase of an equipment to save its costs. The relevant data for net present value analysis of the equipment is given below:

• Cost of the equipment: $240,000
• Expected annual cash savings before tax to be provided by the equipment: $100,000
• Useful life of the equipment: 6 years
• Expected residual or salvage value of the equipment at the end of 6 year period: $30,000
• Tax rate: 40%
• Discount rate: 12%

The equipment is to be depreciated using straight line method of depreciation. The company does not deduct salvage value from the cost of the equipment for computing depreciation for tax purpose.

Required: Determine net present value of the investment.

Solution:

Depreciation = $240,000/6 years
= $40,000

* Value from present value of an annuity of $1 in arrears table.
** Value from present value of $1 table.

Residual value (salvage value) is taxable because it has not been considered while computing depreciation. At the end of the useful life, the equipment will have a book value of zero.