In capital budgeting analysis, tax can have a significant impact. The capital budgeting items will most likely be influenced by tax and hence, the values need to be adjusted. It is important to understand taxed capital budgeting items so that the calculation can have better accuracy.
Firstly, the relevant cash flows must be determined correctly. The most difficult phase of capital budgeting is forecasting and estimating the relevant cash flows (Brigham & Houston, 2019). It is important to consider only relevant cash flow in estimating future cash flows for clarity of decision-making. Managers should be careful in observing costs, such as sunk costs, opportunity costs, and income taxes, as they may have a significant effect on the capital budgeting decision.
Income taxes should be incorporated into the capital budgeting calculation when estimating future cash flows from operating activities. Heisinger and Hoyle (2012) analyzed four capital budgeting items and their relation to income taxes. The four items and the explanations are as follow.
- Investment cash outflows are not adjusted for income taxes.
The initial investment purchase price is not expensed immediately, but rather spread over its lifetime through depreciation. This way, the large cost of the capitalized asset would not directly affect net income. Hence, the investment cash outflows are not adjusted for income taxes.
- Initial working capital cash flows are not adjusted for income taxes
The working capital required for a project will affect the cash flows (Taxmann, 2022). However, the additional working capital is needed only for the project’s lifetime period. Hence, for evaluation purposes, it is generally treated as an initial investment and to be fully recovered at the end of the project (Working Capital, n.d.).
While initial working capital addition is a relevant cash flow in capital budgeting, it does not directly affect net income in the income statement. Thus, the additional investments will not affect income taxes, and there is no need for tax adjustment.
- Revenue cash inflows and expense cash outflows are adjusted for income taxes
All revenues and expenses directly affect net income and so, they affect income taxes paid. The net cash flows (the revenue subtracted by the expenses) should be adjusted for income taxes. The income taxes would be the net income multiplied by the tax rate. Thus, for the tax adjustment, the net cash flows should be multiplied by one minus the tax rate.
- Depreciation expenses are providing tax reduction
Even though depreciation expense is not a cash outflow, it has a direct effect on the income statement (Merritt, 2019). Hence, it reduces taxable income. The annual tax saving from depreciation expense can be calculated by multiplying the depreciation expense with the tax rate. It is what is usually referred to as the tax shield from depreciation expenses.
Also read about Depreciation Expenses in Capital Projects and Leasing Arrangements
Another item that has to be considered is salvage value. The sale of an old asset may result in some profit or loss that would affect the taxable income. The profit on the sale would involve additional tax payment and a loss on the sale would result in tax savings (Taxmann, 2022).
To correctly perform capital budgeting analysis, it is vital to understand which are the taxed capital budgeting items and which are not. The four points above may provide a brief insight on the issue.
References Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management (15th ed.). Cengage Learning. Heisinger, K., & Hoyle, J. B. (2012). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html Merritt, C. (2019). What Is the Impact of Depreciation Expense on Profitability? Small Business - Chron.Com. https://smallbusiness.chron.com/impact-depreciation-expense-profitability-55349.html Taxmann. (2022). Treatise on Capital Budgeting: Estimation of Cash Flows. https://www.taxmann.com/post/blog/treatise-on-capital-budgeting-estimation-of-cash-flows/ Working Capital. (n.d.). The Pennsylvania State University. Retrieved July 2, 2022, from https://www.e-education.psu.edu/eme460/node/679
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