1. Taxes as Transaction Costs
Chapter 3
Taxes as Transaction Costs
McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Objectives
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. Taxes 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

4. Time 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

5. Time 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

6. Discount Rate = r 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

7. Present Value Formula Present value formula
Where:
PV($1) = Present value of one dollar today
r = Interest rate
n = Number of periods

8. Time Value of Money - Terminology
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 Time Time Time Time 4

9. Time Value of Money - Terminology
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 Time Time Time Time 4

10. Present Value of Ordinary Annuity
Formula for present value of an ordinary annuity
Where:
Pa = Present value of ordinary annuity
r = Interest rate
n = Number of periods

11. Present 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

12. Present 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

13. Risk
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

14. Tax 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

15. Taxes 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

16. Relation 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 × ( ) = $650
Christie: $1,000 × ( ) = $850

17. Taxes 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)

18. Taxes and Cash Flows - Step By Step
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

19. Taxes and Cash Flows - Step By Step
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

20. Taxes and Cash Flows - Step By Step
Time 0
Year 1
Year 2
Year 3
BTCF
(3,000)
4,000
TAXABLE
3,000
2,500
3,500
TAX
(900)
(750)
(1,050)
ATCF
3,100
3,250
2,950 PV
2,818
2,686
2,216
NPV
4,720

21. Taxes and Cash Flows - Other Issues
Several tax-related uncertainties add complexity to the tax planning process
Audit risk
Tax law uncertainty
Marginal rate uncertainty

22. Audit 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

23. Tax 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

24. 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

25. Marginal 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

26. Structuring 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!

27. Structuring Transactions
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

28. Structuring Transactions
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

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

30. Structuring Transactions
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