Chapter 3 Taxes as Transaction Costs McGraw-Hill Education Copyright © 2015 by McGraw-Hill...

Chapter 3Chapter 3

Taxes as Transaction CostsTaxes as Transaction Costs

McGraw-Hill Education Copyright © 2015 by McGraw-Hill Education. All rights reserved.

3-2

ObjectivesObjectives

• Compute the tax cost of an income item and the tax savings from a deduction

• Integrate tax costs and savings into NPV calculations• Identify the uncertainties concerning future tax costs and

savings• Explain why tax minimization may not be the optimal

business strategy• Explain why bilateral tax planning is important in private

market transactions• Distinguish between arm’s length and related-party

transactions

3-3

Taxes as Transaction CostTaxes as Transaction Cost

• The objective of business decisions is to maximize the value of the firm

• The first step in evaluating a business transaction is to quantify cash flows from the transaction

• Managers want to make decisions that maximize the value of the firm by maximizing positive cash flow or minimizing negative cash flow

3-4

Time Value of MoneyTime Value of Money

• When cash flows from a transaction occur at different times, quantification of net cash flow should take into account the time value of money

• Time value of money: a dollar received today is worth more than a dollar to be received in a future period

3-5

Time Value of Money - TerminologyTime Value of Money - Terminology

• Present value: Value of a dollar today• Discount rate: Rate of interest on invested funds for

deferral period• Net present value (NPV): Sum of present values of

cash inflows and outflows from a transaction

3-6

Discount Rate = Discount Rate = rr

• As r increases, how does present value change?

• Present value decreases

• How is r related to risk?

• The riskier the project, the higher the r

• Should you always use the same r to evaluate different planning schemes?

• Only if the different schemes have equal risk

3-7

Present Value FormulaPresent Value Formula

• Present value formula

nrPV

)1(

1)1($

Where:PV($1) = Present value of one dollar todayr = Interest raten = Number of periods

3-8


• Present value of an ordinary annuity• The value today of a series of constant dollar payments

available at the end of each period for a specific number of periods

I--------xI---------xI----------xI----------xI Time 0 Time 1 Time 2 Time 3 Time 4

3-9


• Present value of an annuity due• The value today of a series of constant dollar payments

available at the beginning of each period for a specific number of periods

Ix--------Ix---------Ix----------Ix----------I Time 0 Time 1 Time 2 Time 3 Time 4

3-10

Present Value of Ordinary AnnuityPresent Value of Ordinary Annuity

• Formula for present value of an ordinary annuity

na rrrP

)1(

11

Where:Pa = Present value of ordinary

annuityr = Interest raten = Number of periods

3-11

Present Value ExamplePresent Value Example

• At the beginning of your freshman year, your uncle makes the following offer:• Receive $20,000 when you graduate after four years, or • Receive $15,000 now

• Present value of $20,000 at a 10% discount rate is $13,660

• Should you take your uncle’s offer of $15,000 now? • Yes! $15,000 now is worth more than $20,000 in four

years

3-12

Present Value of Ordinary AnnuityPresent Value of Ordinary Annuity

• Assume your uncle makes the following offer:• Receive four $15,000 payments at the end of your

freshman through senior year (ordinary annuity), or• Receive $46,000 now

• Present value of the annuity at a 10% discount rate is $47,548

• Should you take your uncle’s offer of $46,000 now?• No, the annuity has the greater present value

3-13

RiskRisk

• Many classroom examples (like the ones above) assume that all cash flows are equally risky

• Higher risk projects demand higher expected returns which means a higher discount rate

• Assume that discount rates stated in all examples reflect the correct risk and that the risk does not change over time

3-14

Tax Costs as Cash FlowsTax Costs as Cash Flows

• If a transaction results in an increase in any tax for any period, the increase (tax cost) is a cash outflow

• If a transaction results in a decrease in any tax for any period, the decrease (tax savings) is a cash inflow

3-15

Taxes and Cash FlowsTaxes and Cash Flows

• If cash inflow is nontaxable, after-tax cash inflow = before-tax cash inflow

• If cash outflow is nondeductible, after-tax cash outflow = before-tax cash outflow

• If cash inflow is taxable, after-tax cash inflow = before-tax cash inflow × (1- t)

• If cash outflow is deductible, after-tax cash outflow = before-tax cash outflow × (1- t)• t = marginal tax rate

3-16

Relation Between Taxes and Cash FlowsRelation Between Taxes and Cash Flows

• Does the after-tax cost of a deductible expense increase or decrease as the taxpayer’s marginal income tax rate increases?

• Example: Bosco is in the 35% bracket. Christie is in the 15% bracket. Each taxpayer pays $1,000 in deductible student loan interest

• What is their after-tax interest cost?• Bosco: $1,000 × (1 - .35) = $650• Christie: $1,000 × (1 - .15) = $850

3-17

Taxes and Cash Flows - Step By StepTaxes and Cash Flows - Step By Step

• Determine before-tax cash inflows and outflows (BTCF) from transaction or activity

• Determine taxable income and deductions

• Taxable income may not be equal to cash inflows (e.g. sales of inventory on credit)

• Deductible expenses may not be equal to cash outflows (e.g. depreciation)

3-18


• Compute tax cost of income and tax savings from deductions

• Compute net after-tax cash inflows or outflows (ATCF) from transaction or activity

• Compute NPV of net cash flows using an appropriate discount rate

3-19


• George buys a computer for $3,000 today

• He expects to earn $4,000 cash revenues in each of the next three years by designing web pages

• He can deduct the cost of the computer as follows: year 1 $1,000; year 2 $1,500; year 3 $500

• He expects to be in a 30% tax bracket for all three years

• Compute NPV of George’s after-tax cash flows using a 10% discount rate

3-20


Time 0 Year 1 Year 2 Year 3

BTCF (3,000) 4,000 4,000 4,000

TAXABLE 0 3,000 2,500 3,500

TAX 0 (900) (750) (1,050)

ATCF (3,000) 3,100 3,250 2,950

PV (3,000) 2,818 2,686 2,216

NPV 4,720

3-21

Taxes and Cash Flows - Other IssuesTaxes and Cash Flows - Other Issues

• Several tax-related uncertainties add complexity to the tax planning process

• Audit risk

• Tax law uncertainty

• Marginal rate uncertainty

3-22

Audit RiskAudit Risk

• If the tax law is unclear as to the correct treatment of a transaction, the IRS may challenge the taxpayer’s treatment upon audit

• The taxpayer may owe additional tax, interest, and possibly penalties

• The taxpayer’s cost of litigation can be substantial

• Managers can reduce audit risk by engaging a tax professional or requesting a private letter ruling from the IRS

3-23

Tax Law UncertaintyTax Law Uncertainty

• The tax law may change during the time period of the NPV computation

• For example, capital gains rates change on a frequent basis

3-24

Quiz!Quiz!

• Which type of tax law provision should be more stable and less uncertain as to its future application?

a. A provision relating to the proper measurement of taxable income

b. A provision designed to encourage taxpayers to engage in certain economic behavior

• Answer: a

3-25

Marginal Rate UncertaintyMarginal Rate Uncertainty

• The taxpayer may not be able to accurately forecast his future situation

• Actual marginal tax rate for future years may vary from the projected rate

3-26

Structuring TransactionsStructuring Transactions

• Tax consequences of business transactions depend on the legal and financial structure of the transaction. • Firms can change tax consequences by changing the

legal or financial structures.

• However, if a change that saves tax dollars adversely affects other non-tax factors, the change may be a bad idea!

3-27


• The extent to which managers can control the tax consequence of transactions depends on the nature of the market in with the transaction occurs

• Private market• Public market• Fictional market between related parties

3-28


• Private market• Both parties can customize the transaction to minimize

the aggregate tax cost. • Tax savings can be shared between the parties• Examples:

• Executive and employer

• Merger target and acquirer

3-29


• Public market• The parties do not engage in direct negotiation• Tax planning is one-sided• Example: Your first job

3-30


• Fictional market between related parties

• If related parties are not dealing at arms length, no true market exists and any transaction between them may not reflect economic reality

• The IRS may disallow any favorable tax treatment

Chapter 3 Taxes as Transaction Costs McGraw-Hill Education Copyright © 2015 by McGraw-Hill...

Documents

Transcript of Chapter 3 Taxes as Transaction Costs McGraw-Hill Education Copyright © 2015 by McGraw-Hill...