Impact of income tax on capital budgeting decisions

The income tax usually has a significant impact on the cash flow of a company and therefore needs to be taken into account while making capital budgeting decisions. An investment that looks desirable without considering income tax may become unacceptable after considering it. Before explaining the impact of income tax on capital budgeting decisions using a net present value (NPV) example, we need to understand three important concepts. These concepts are after-tax benefit, after-tax cost and depreciation tax shield. Let’s briefly explain and exemplify each and then apply them in the computation of a NPV of a project.

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, we use after-tax cash inflow. 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 $500,000 cash from its operations. The tax rate of the company is 40%. Compute after-tax cash inflow.

Solution:

After-tax benefit or after-tax cash inflow = (1 – Tax rate) × Taxable cash receipt
= (1 – 0.4) × $500,000
= 0.6 × $500,000
= $300,000

After-tax cost:

A tax deductible cost reduces taxable income of the entity and helps save its income tax. A cost net of its tax effect is known as after-tax cost and 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 it $70,000. The cost of training program is a tax deductible cost for the company. Compute after-tax cost of training program if tax rate of the company is 40%.

Solution:

After-tax cost or after tax cash outflow = (1 – Tax rate) × Tax deductible cash expense
= (1 – 0.4) × $70,000
= 0.6 × $70,000
= $42,000

Depreciation tax shield:

Depreciation is a non-cash tax deductible expense that saves income tax for business entities by reducing their taxable income. The amount of tax that the annual depreciation of an entity saves 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 expense of a company is $50,000 and its tax rate is 40%. Compute tax savings from depreciation (i.e., depreciation tax shield).

Solution:

Depreciation tax shield = Tax rate × Depreciation deduction
= 0.4 × $50,000
= $20,000

Capital budgeting with income tax:

Since we have learned the concept of after-tax cash inflow, after-tax cost and depreciation tax shield, now 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.

We can also present the solution in horizontal format as follows:

($100,000 x 0.6 x 4.111) + ($40,000 x 0.4 x 4.111) + ($30,000 x 0.6 x 0.507) – ($240,000 x 1.000)
= $246,660 + $65,776 + $9,126 – $240,000
= $81,562 NPV