6A:002 – Berg
Taxes and Capital Budgeting
Page 1
Supplement  Chapter 9
Taxes and Capital Budgeting Decisions
In Chapter 9, we examine capital budgeting decision making.
Because the costs and benefits of
these decisions occur over time periods much longer than one year, we need a way to incorporate
the fact that a dollar received today is worth more than a dollar received 10 years from now.
Discounting (computing net present value) is one way to do this.
Because it is cash, and not
accounting earnings, that earns interest, we evaluate cash flows rather than accounting earnings
when computing net present value.
One consideration excluded from the analysis in Chapter 9, is the impact of taxes.
While the
firm faces many kinds of taxes, we will consider only federal income taxes.
As we did when
discussing Cost Volume Profit analysis, we will assume that federal income tax is a percentage
of net income.
Because net income is computed using accounting earnings, not cash flows, we
will need to think about how these two measures differ in order to evaluate the effect of taxes.
Recall that there are three primary types of cash flows associated with a capital budgeting
project:
(1)
An initial cash outflow for the investment in the project.
Generally we assume that this
happens at the very beginning of the project (time 0).
(2)
Periodic future cash inflows from the project.
These are the additional revenues and
decreases in costs that result from the project.
We assume they happen at the end of the
period (times 1, 2, etc)
(3)
A onetime cash inflow that happens at the end of the life of the project.
We call this the
residual value
.
The impact of taxes on each of these items is discussed below.
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 Spring '11
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 Depreciation, Net Present Value, depreciation tax shield

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