1. McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Principles of Taxation Chapter 3 Taxes as Transaction Costs

2. Slide 3-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Objectives  Compute tax costs of income and tax savings from deductions.  Compute net present value of after-tax cash flows.  Identify sources of tax uncertainty  Maximize after-tax values versus minimize taxes.  Tax planning in private market transactions.  Distinguish arm’s length from related-party transactions.

3. Slide 3-3 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Taxes as transaction cost  Goal - MAXIMIZE ________________values,  NOT MINIMIZE TAXES

4. Slide 3-4 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Time Value of Money  Terminology  Present Value Example  Future Value Example  Present Value of an Annuity Example  Future Value of an Annuity Example

5. Slide 3-5 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Time Value of Money - Terminology  Time Value of Money: This refers to the notion that a dollar available today is worth more than a dollar to be received in some future period.  Define Present value:  Discount Rate  The rate of interest on invested funds for the deferral period.  As r increases, what does the present value do? How is r related to risk? Should you always use the same r to evaluate 2 different planning schemes? Q1, 2  Define Net Present Value:

6. Slide 3-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Time Value of Money - Terminology  Define Future Value  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.  Future Value of an Ordinary Annuity  The value at a future date of a series of constant dollar payments available at the end of each period for a specific number of periods increased by an interest rate.

7. Slide 3-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value Example  Assume that at the beginning of your freshman year your great Uncle makes the following offer:  Receive $20,000 on your graduation day 4 years hence, or  Receive $15,000 now.  How do you decide?  To compare the $20,000 with the $15,000 you must compare them in present value terms. In other words, what is the present value of the $20,000 and how does that compare to $15,000?

8. Slide 3-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value Example  Present value formula Where : PV($1) = Present value of one dollar today r= Interest Rate n= Number of Periods

9. Slide 3-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value Example  Let’s assume you expect an annual interest rate of 10% on invested funds. Specifying an annual rate also determines the number of periods 4 (4 years till graduation). Use 10% for R, and 4 for n.  The present value of the $20,000 using a 10 percent discount rate is $___________. Thus, should you take your Uncle’s offer of $15,000 today?

10. Slide 3-10 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value of an Ordinary Annuity  Assume your great Uncle feels particularly generous and makes the following offer:  Receive 4 payments of $15,000 at the end of your freshman through senior year, or  Receive $46,000 now  The first option is an example of an ordinary annuity.

11. Slide 3-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value of an Ordinary Annuity  Formula for the Present Value of an Ordinary Annuity Where: P a = Present value of Ordinary Annuity r = Interest Rate n = Number of Periods

12. Slide 3-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Present Value of an Ordinary Annuity  Keeping with our previous examples (a 10 percent annual interest rate for 4 periods) the present value of the annuity is $____________. Thus, you should choose the ANNUITY.

13. Slide 3-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Risk  Many classroom examples (like the ones above) assume that all cash flows are equally risky.  Higher risk projects demand higher expected returns = higher discount rate.  Assume that discount rates state in examples already reflect the relative risk of the transaction, and that the risk does not change over time.

14. Slide 3-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Relation Between Taxes and Cash Flows - Step by Step  1) Determine yearly PRE-TAX cash inflows and outflows.  2) Determine yearly TAXABLE income and deductions. Taxable income may not be equal to cash inflows. Deductible expenses may not be equal to cash outflows (e.g. depreciation).  3) Compute yearly cash outflows to pay TAX on taxable income and cash inflow from tax deductions = 2) x MTR.  4) Compute yearly net AFTER-TAX cash inflows or outflows. 1) - 3)  5) Compute NPV of yearly net cash flows.

15. Slide 3-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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? Q3, Q5  Example: Bosco is in the 36% bracket. Christie is in the 15% bracket. Each taxpayer pays $10,000 in home mortgage interest. Assuming they can each itemize and deduct the interest expense, what is their after tax interest cost, respectively.

16. Slide 3-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Relation Between Taxes and Cash Flows - Step by Step  George buys a computer for $3000 in 1998. He expects to earn $4000 in cash revenues each of the next three years designing web pages. For tax purposes, he can deduct the cost of the computer as follows: year 1: $1000, year 2: $1500, year 3: 500. He expects to be in a 28% tax bracket for all three years. Assume a discount rate of 10%. What is the net present value of his after-tax cash flows?

17. Slide 3-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Relation Between Taxes and Cash Flows - Step by Step  Use steps 1 - 5

18. Slide 3-18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Relation Between Taxes and Cash Flows - Other Issues  The marginal tax rate that applies (Step 3) may differ by type of income.  See AP 2, 3, Q5.  Most of the problems and examples in the text assume that payments occur at the BEGINNING of the year.

19. Slide 3-19 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Tax Uncertainty  Audit risk - the tax law may be unclear - risk that the IRS may disagree with taxpayer treatment. Possible interest plus penalties plus tax.  Tax law uncertainty - the tax law may change. For example, the capital gains rates and holding periods have changed frequently. See Q7, 8.  Marginal rate uncertainty - the taxpayer may not be able to predict annual income and tax position at the time transaction happens. See Q10, IR1.

20. Slide 3-20 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Structuring Transactions  Private market - both parties can customize the transaction. Examples? See IR8, TPC1.  Public market - without direct negotiation, tax planning is one-sided.  Related party markets - extreme tax avoidance may create suspicion of tax evasion. Q12.