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I. Appendix 13C: Income taxes and the net present value
method (Slide #1 is the title slide for this appendix)
Learning Objective 8: Include income taxes in a net present
value analysis.
A. Six simplifying assumptions
i. A company’s net income for financial reporting
purposes equals its taxable income.
ii. The tax rate is a flat percentage of taxable income.
iii. A noncurrent asset’s useful life is the same for
financial reporting and tax purposes.
iv. Straight-line depreciation is always used for
financial reporting and tax purposes.
v. Noncurrent assets always have a salvage value of
zero for financial reporting and tax purposes.
vi. There are no gains or losses on the sale of
noncurrent assets.
B. Key concepts
i. To calculate the amount of income tax expense
associated with a capital budgeting project, we’ll be
using a two-step process:
1. The first step is to calculate the incremental net
income earned during each year of the project.
2. The second step is to multiply each year’s
incremental net income by the tax rate to
determine the income tax expense.
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ii. A capital budgeting project’s incremental net
income computations include:
1. Annual revenues.
2. Annual cash operating expenses.
3. Annual depreciation expense.
4. One-time expenses related to repairs and
maintenance.
iii. A capital budgeting project’s incremental net
income computations exclude:
1. Immediate investments in equipment, other assets,
and installation costs.
2. Investments in working capital.
3. The release of working capital.
4. The proceeds from selling a noncurrent asset
when no gain or loss is realized on the sale.
C. Income taxes and net present value analysis: an example
i. Holland Company owns the mineral rights to land
that has a deposit of ore. The company is deciding
whether to purchase equipment and open a mine on
the property. The mine would be depleted and
closed in 5 years at which time the working capital
would be released and redeployed by the company.
ii. Pertinent financial information is as shown. In
addition to this information, the company uses
straight-line depreciation for financial reporting
and tax purposes.
1. Should Holland open a mine on the property?
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iii. The incremental net income computations include
the annual sales ($250,000), the annual cash
operating expenses ($150,000), the road repairs in
year three ($30,000), and the annual depreciation
expense of $55,000 ($275,000 ÷ 5 years =
$55,000).
1. The incremental net income in years 1, 2, 4, and 5
is $45,000, whereas in year 3 it is $15,000.
iv. Each year’s incremental net income is multiplied
by the tax rate of 30% to determine the income tax
expense.
1. The income tax expense in years 1, 2, 4, and 5 is
$13,500, whereas in year 3 it is $4,500.
v. The net present value computations include the
initial outlays for the purchase of equipment
($275,000) and the investment in working capital
($50,000), the annual sales ($250,000), the annual
cash operating expenses ($150,000), the road
repairs in years three ($30,000), the release of
working capital in year five ($50,000), and the
annual income tax expense.
vi. Each year’s total cash flows are multiplied by the
appropriate discount factor for 12% to compute
their lesser present value. For example:
1. The total cash flows in year 3 of $65,500 are
multiplied by the discount factor of 0.712 to
obtain their lesser present value of $46,636.
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vii. The present values in cells B22 through G22 are
combined to determine the project’s net present
value of $231. Because the net present value is
positive, it indicates that Holland Company should
proceed with the mining project.
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