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Chapter 3
Taxes as Transaction
Costs
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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.
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Taxes as Transaction Cost
• The overall objective of business decisions is to
maximize the value of the firm.
• The first step in evaluating a business transaction is
to quantify the cash flows from the transaction.
• Managers want to make decisions that maximize
the value of the firm by maximizing positive cash
flows or minimizing negative cash flow.
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Time Value of Money
• When cash flows from a transaction occur at
different times, the 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 some
future period.
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Time Value of Money - Terminology
• Present value: the value of a dollar today.
• Discount Rate: the rate of interest on invested
funds for the deferral period.
• Net Present Value: the sum of the present
values of cash inflows and outflows relating to a
transaction.
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Discount Rate
• As r increases, what does the present value do?
• It decreases.
• How is r related to risk?
• The riskier the project, the higher the discount rate.
• Should you always use the same r to evaluate 2
different planning schemes?
• Only if they are of the same risk.
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Present Value Formula
• Present value formula
1
PV ($ 1 ) 
(1  r ) n
Where :
PV($1) = Present value of one dollar today
r
= Interest Rate
n
= Number of Periods
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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 0
Time 1
Time 2
Time 3
Time 4
• 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
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Present Value of an Ordinary Annuity
• Formula for the Present Value of an Ordinary
Annuity
1
1
Pa  
n
r r (1  r )
Where:
Pa = Present value of Ordinary Annuity
r = Interest Rate
n = Number of Periods
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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.
• The present value of $20,000 using a 10% discount
rate is $13,660.
• Should you take your Uncle’s offer of $15,000
today?
• Yes! $15,000 today is worth more than $20,000 in
four years.
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Present Value of an Ordinary Annuity
• Assume your Uncle feels particularly generous and
makes the following offer:
• Receive 4 payments of $15,000 at the end of your
freshman through senior year (i.e., ordinary annuity), or
• Receive $46,000 now.
• Using a 10 percent annual interest rate for 4 periods, the
present value of the annuity is $47,548.
• What to do?
• Wait and take the four payments as the present value of the
annuity is greater than the $46,000 to be received now.
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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 examples
already reflect the relative risk of the transaction,
and that the risk does not change over time.
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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.
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Taxes and Cash Flows
• If cash flow is nontaxable, after-tax cash flow =
pretax cash flow.
• If cash expense is nondeductible, after-tax cash
cost = pretax cash cost.
• If cash flow is taxable, after-tax cash flow = pretax
cash flow x (1-t).
• If cash expense is deductible, after-tax cash cost =
pretax cash cost x (1-t).
• where t = marginal tax rate
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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 costs, respectively?
• Bosco: $1,000 x (1 - .35) = $650
• Christie: $1,000 x (1 - .15) = $850
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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 (e.g.
sales of inventory on credit).
• Deductible expenses may not be equal to cash outflows
(e.g. depreciation).
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Relation Between Taxes and Cash Flows - Step By
Step
• 3) Compute yearly cash outflows to pay TAX on
taxable income and cash inflow from tax
deductions.
• 4) Compute yearly net AFTER-TAX (ATCF) cash
inflows or outflows. Step 1 +/- Step 3
• 5) Compute NPV of yearly net cash flows using an
appropriate discount rate.
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Relation Between Taxes and Cash Flows - Step
By Step
• George buys a computer for $3,000 at time
zero. He expects to earn $4,000 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:
$1,000, year 2: $1,500, year 3: $500. He
expects to be in a 30% tax bracket for all three
years. Assume a discount rate of 10%. What is
the net present value of his after-tax cash flows?
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Relation Between Taxes and Cash Flows - Step
By Step
•Use steps 1 - 5
Time 0 Year 1 Year 2 Year 3
CASH
(3,000) 4,000
4,000
4,000
TAXABLE
TAX
ATCF
PV
NPV
0
0
(3,000)
(3,000)
2,500
(750)
3,250
2,686
3,500
(1,050)
2,950
2,216
4,720
3,000
(900)
3,100
2,818
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Relation Between Taxes and Cash Flows - Other
Issues
•
Tax law uncertainty - The tax law may change during
the time period of the NPV computation. For
example, the capital gains rates and holding periods
have changed frequently.
• Q8. 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 individual
taxpayers to engage in certain economic behavior.
• Answer: A
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Tax Uncertainty
• Audit risk : The tax law may be unclear; as such,
there is the risk that the IRS may disagree with
taxpayer treatment.
• The financial risk consists of possible interest plus
penalties plus tax. Even if the taxpayer wins its case, the
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.
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Tax Law Uncertainty
•
Tax law uncertainty: The tax law may change
during the time period of the NPV
computation.
•
For example, capital gains rates and holding
periods have historically changed on a frequent
basis.
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Question 8:
•
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
individual taxpayers to engage in certain
economic behavior.
• Answer: A
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Tax Uncertainty
• Marginal rate uncertainty : The taxpayer may not be
able to predict annual income and tax position at
the time the transaction happens.
• Thus, the actual marginal tax rate for the year may
vary from the project rate.
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Structuring Transactions
• The tax consequences of business transactions
depend on the legal and financial structure of the
transaction. Firms can change the 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.
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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.
1) Private market.
2) Public market.
3) Related party markets.
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Structuring Transactions
• Private market :
• Both parties can customize the transaction in order to
minimize the aggregate tax cost of the transaction. The
tax savings can then be shared.
• Examples:
• executive and employer,
• merger target and acquirer
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Structuring Transactions
• Public Market – without direct negotiation
• Tax Planning is one-sided.
• Example: Your first job.
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Structuring Transactions
• Related Party Markets – 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.
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•