The impact of income taxes on capital budgeting decisions:

The income tax usually has 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

Example 1:

ABC company generated $10,000 cash from its operations. The tax rate of the company is 30%.
Compute after-tax cash inflow.

Solution:

After-tax benefit or after-tax cash inflow = (1 – Tax rate) × Taxable cash receipt

= (1 – 0.3) × $10,000

= 0.7 × $10,000

= $7,000

After-tax cost:
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

Example 2:

A company wants to start a training program that will cost $50,000. The training program is a tax-
deductible cost for the company. Compute after-tax cost of training program if tax rate of the company
is 30%.

Solution:

After-tax cost or after-tax cash outflow = (1 – Tax rate) × Tax deductible cash expense

= (1 – 0.3) × $50,000

= 0.7 × $50,000

= $35,000

1
 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

Example 3:

The annual tax-deductible depreciation of a company is $25,000 and tax rate is 30%. Compute tax
savings from depreciation (depreciation tax shield).

Solution:

Depreciation tax shield = Tax rate × Depreciation deduction

= 0.3 × $25,000

= $7,500

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dgeting-decisions/