Chapter 3
Taxes as Transaction Costs
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
3-2
Objectives
• Compute the tax cost of an income item and the tax savings
from a deduction
• Integrate tax costs and savings into NPV calculations
• Identify the uncertainties concerning future tax costs and
savings
• Explain why tax minimization may not be the optimal
business strategy
• Explain why bilateral tax planning is important in private
market transactions
• Distinguish between arm’s length and related-party
transactions
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Taxes as Transaction Cost
• The objective of business decisions is to maximize
the value of the firm
• The first step in evaluating a business transaction is
to quantify cash flows from the transaction
• Managers want to make decisions that maximize
the value of the firm by maximizing positive cash
flow or minimizing negative cash flow
3-4
Time Value of Money
• When cash flows from a transaction occur at
different times, 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 a future
period
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Time Value of Money - Terminology
• Present value: Value of a dollar today
• Discount rate: Rate of interest on invested funds for the
deferral period
• Net present value (NPV): Sum of the present values of
cash inflows and outflows relating to a transaction
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Discount Rate = r
• As r increases, how does present value change?
• It decreases
• How is r related to risk?
• The riskier the project, the higher the r
• Should you always use the same r to evaluate
different planning schemes?
• Only if the different schemes have equal risk
3-7
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
3-8
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
3-9
Time Value of Money - Terminology
• 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
3-10
Present Value of Ordinary Annuity
• Formula for 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
3-11
Present Value Example
• At the beginning of your freshman year, your uncle
makes the following offer:
• Receive $20,000 when you graduate after four years, or
• Receive $15,000 now
• The present value of $20,000 at a 10% discount
rate is $13,660
• Should you take your uncle’s offer of $15,000 now?
• Yes! $15,000 now is worth more than $20,000 in four
years
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Present Value of Ordinary Annuity
• Assume your uncle makes the following offer:
• Receive four $15,000 payments at the end of your
freshman through senior year (ordinary annuity), or
• Receive $46,000 now
• The present value of the annuity at a 10% discount
rate is $47,548
• Should you take your uncle’s offer of $46,000 now?
• No, you should take the annuity because it has the
greater present value
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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 all examples
reflect the correct risk and that the risk does not
change over time
3-14
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 inflow is nontaxable, after-tax cash inflow =
before-tax cash inflow
• If cash outflow is nondeductible, after-tax cash
outflow = before-tax cash outflow
• If cash inflow is taxable, after-tax cash inflow =
before-tax cash inflow × (1- t)
• If cash outflow is deductible, after-tax cash outflow
= before-tax cash outflow × (1- t)
• 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 cost?
• Bosco: $1,000 × (1 - .35) = $650
• Christie: $1,000 × (1 - .15) = $850
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Taxes and Cash Flows - Step By Step
• Determine before-tax cash inflows and outflows
(BTCF) from the transaction or activity
• Determine 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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Taxes and Cash Flows - Step By Step
• Compute tax cost of income and tax savings from
deductions
• Compute net after-tax cash inflows or outflows
(ATCF) from the transaction or activity
• Compute NPV of net cash flows using an
appropriate discount rate
3-19
Taxes and Cash Flows - Step By Step
• George buys a computer for $3,000 today
• He expects to earn $4,000 cash revenues in each of the
next three years by designing web pages
• 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
• Compute the NPV of his after-tax cash flows using
a 10% discount rate
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Taxes and Cash Flows - Step By Step
Time 0 Year 1 Year 2 Year 3
BTCF
TAXABLE
TAX
ATCF
PV
NPV
(3,000)
0
0
4,000
4,000
4,000
3,000
2,500
3,500
(900)
(750)
(1,050)
(3,000)
3,100
3,250
2,950
(3,000)
2,818
2,686
2,216
4,720
3-21
Taxes and Cash Flows - Other Issues
• Several tax-related uncertainties add complexity to
the tax planning process
• Audit risk
• Tax law uncertainty
• Marginal rate uncertainty
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Audit Risk
• If the tax law is unclear as to the correct treatment
of a transaction, the IRS may challenge the
taxpayer’s treatment upon audit
• The taxpayer may owe additional tax, interest, and
possibly penalties
• The taxpayer’s 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
• The tax law may change during the time
period of the NPV computation
• For example, capital gains rates change on a
frequent basis
3-24
Quiz!
• 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 taxpayers
to engage in certain economic behavior
• Answer: a
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Marginal Rate Uncertainty
• The taxpayer may not be able to accurately forecast
his future situation
• Actual marginal tax rate for future years may vary
from the projected rate
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Structuring Transactions
• Tax consequences of business transactions depend
on the legal and financial structure of the
transaction.
• Firms can change 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
• Private market
• Public market
• Fictional market between related parties
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Structuring Transactions
• Private market
• Both parties can customize the transaction to minimize
the aggregate tax cost.
• Tax savings can be shared between the parties
• Examples:
• Executive and employer
• Merger target and acquirer
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Structuring Transactions
• Public market
• The parties do not engage in direct negotiation
• Tax planning is one-sided
• Example: Your first job
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Structuring Transactions
• Fictional market between related parties
• 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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