The income tax usually have a significant effect on the cash flow of a company and should be taken into account while making capital budgeting decisions. An investment that looks desirable without considering income tax may become unacceptable after considering income tax. Before explaining the impact of income tax on capital budgeting using a net present value example, we need to understand three concepts. These are after-tax benefit, after-tax cost and depreciation tax shield. A brief explanation of each is given below:
After-tax benefit or cash inflow:
Taxable revenues or cash inflows, when reduced by the income tax, are known as after-tax benefit or after-tax cash inflow. When income tax is considered in capital budgeting decisions, after-tax cash inflow is used. An example of taxable cash inflow is cash generated by a company from its operations.
After tax benefit or after tax cash inflow can be easily computed using the following formula:
After-tax benefit or after-tax cash inflow = (1 – Tax rate) × Taxable cash receipt
Tax deductible costs reduce taxable income and help save income tax. A cost net of its tax effect is known as after-tax cost. After-tax cost can be computed using the following formula:
After-tax cost or after tax cash outflow = (1 – Tax rate) × Tax deductible cash expense
Depreciation Tax shield:
Depreciation is a non-cash tax deductible expense that saves income tax by reducing taxable income. The amount of tax that is saved by depreciation is known as depreciation tax shield. The formula to compute depreciation tax shield is as follows:
Depreciation tax shield = Tax rate × Depreciation deduction
The day-to-day decisions a small business owner makes are typically operational — how much to charge, for example, or how to arrange a store or how many employees to schedule. But businesses also have to make capital decisions, determining the best projects to invest in to ensure growth and future profitability. Capital budgeting is how businesses make such decisions. Capital structure tells you where the money for capital projects comes from.
Capital budgeting is simply the process of deciding which capital projects to pursue and which to reject. At any given time, a business may have countless projects it could pursue. Even a project as straightforward as opening a new store could go in multiple directions: where to put it, how big it should be, what product mix it should offer and so on. A business can’t — and shouldn’t — pursue every possible project. For one thing, you only have so many resources. Also, some projects are mutually exclusive, and projects might not even be profitable when all costs are considered. Capital budgeting separates the promising projects from the bad ones.