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Center for International Business Education and Development Taxes & Investment Decisions Ohio University Executive Education Seminar Toby Stock, Ph.D., CPA Freeman Professor of Accounting

Taxes & Investment Decisions

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Taxes & Investment Decisions. Ohio University Executive Education Seminar Toby Stock, Ph.D., CPA Freeman Professor of Accounting. Decision making and taxes: the After-Tax Cash Flow model. Framework introduction ATCF model definitions Relation between TI and ATCF - PowerPoint PPT Presentation

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Page 1: Taxes & Investment Decisions

Center for International Business Education and Development

Taxes &Investment Decisions

Ohio University

Executive Education Seminar

Toby Stock, Ph.D., CPA

Freeman Professor of Accounting

Page 2: Taxes & Investment Decisions

Framework introduction ATCF model definitions Relation between TI and ATCF ATCF model and rates of return

Decision making and taxes: the After-Tax Cash Flow model

Page 3: Taxes & Investment Decisions

Framework introduction

1. Central theme of this part of the course: make better business decisions by considering...

• ...all parties to the transaction

• ...all taxes from the transaction

• ...all costs and benefits from the transaction.

• Example--

Page 4: Taxes & Investment Decisions

2. Objective function--what are we trying to achieve?

• Tax minimization—NO!

• Cash flow maximization

• Rate of return maximization

Which of these is our goal? Why did you select the answer you selected?

Page 5: Taxes & Investment Decisions

ATCF model definitions• BTCF = before-tax cash flow

– equals the net cash flow from an activity before computing the tax effect from the activity.

• “Adjustments” = any item that causes differences between an activity’s BTCF and the change in taxable income.

• t = tax rate (generally assumed to be a flat rate to keep things simple)

• ATCF = after-tax cash flow– this is the change in one’s wealth from an activity

– firms try to maximize this with their decisions

Page 6: Taxes & Investment Decisions

Relation between TI and ATCF

BTCFBTCF+/- adjustments+/- adjustments

= Taxable income= Taxable income* Tax rates (t)* Tax rates (t)

= Taxes due= Taxes dueBTCFBTCF

- Taxes due- Taxes due

ATCFATCF

LinkLink

...Maximize this...Maximize thisDon’t minimize this...Don’t minimize this...

Problem with tax minimization Problem with tax minimization strategy:strategy:

BTCF = f(TI)BTCF = f(TI)

Page 7: Taxes & Investment Decisions

ATCF model and rates of return

• Can we compare investments/activities with different ATCFs?– problem with comparing ATCFs is that it doesn’t take

the size of the activity into account. Solution:

• BTROR = before-tax rate of return– = BTCF / investment

• ATROR = after-tax rate of return– = ATCF / investment

Page 8: Taxes & Investment Decisions

Insert After-Tax Cash Flow example problem here (Insert #1… file)

Center for International Business Education and Development

Page 9: Taxes & Investment Decisions

Business investment planning• Modeling tax characteristics

• Income-producing investments

• Equity investments

• Deferred investments

• Retirement account investments

• Relation between different investments

• Comprehensive examples

Page 10: Taxes & Investment Decisions

Modeling tax characteristics--Tax Rate

• Ordinary: t– either t0 or tn, depending on whether tax paid

now or in year n.

• Capital gain: g– So g=15% for most LTCGs

• Tax-exempt: 0

Page 11: Taxes & Investment Decisions

Modeling tax characteristics-Frequency

• Annual: [1+R(1-t0)]n

– compounding occurs after taxes paid

– t0 because the current tax rate applies

• Deferred: [1+R]n*(1-tn)– compounding occurs before taxes paid

– tn because the tax rate at the end of the investment term applies

• Never: [1+R]n

– no tax rate because change in TI = R (BTCF) - R (adjustment) = $0

Page 12: Taxes & Investment Decisions

Modeling tax characteristics--investment deductibility

• Investment not deductible– Amount deposited in the investment is the same

as the after-tax cost of the investment (I)• Must add back t to tax-deferred equations

• Investment deductible– Amount deposited in the investment is the

before-tax cost of the investment (I / (1-t0))• Need not add back t to tax-deferred equations

Page 13: Taxes & Investment Decisions

Cash-producing investments

• Rate of taxation =

• Frequency of taxation =

• Investment deductibility =

Page 14: Taxes & Investment Decisions

Investments that distribute CGs(“mutual funds”)

• Rate of taxation =

• Frequency of taxation =

• Investment deductibility =

• Only different from cash-producing investments in the tax rate applied to income (t > g)

Page 15: Taxes & Investment Decisions

Deferred Investments

• Rate of taxation =

• Frequency of taxation =

• Investment deductibility =

• Only different from cash-producing investments in that the investment return compounds tax-free, then is taxed when the income is distributed.

Page 16: Taxes & Investment Decisions

Tax-exempt investments

• Rate of taxation =

• Frequency of taxation =

• Investment deductibility =

Only different from cash-producing investments in that the cash income is tax-free.

Page 17: Taxes & Investment Decisions

Retirement account investments(“Pension plans”)

• Rate of taxation =

• Frequency of taxation =

• Investment deductibility =

• Pension plans differ from deferred investments only in that the initial investment is deductible

Page 18: Taxes & Investment Decisions

Insert Investment Planning Example Here

(Insert #2… file)

Center for International Business Education and Development

Page 19: Taxes & Investment Decisions

Evaluating Investments in Business Entities

Conduits (partnerships) Entities (corporations) Selecting conduit v. entity tax

treatment

Page 20: Taxes & Investment Decisions

• Main idea of this topic: we can use what we know about different investment vehicles to model the future values of investments in partnerships and corporations.– This will allow us to evaluate investments in

these assets just like any passive investment.– The next few slides runs through these

calculations piece by piece. Then we will derive shortcuts using our modeling skills.

Page 21: Taxes & Investment Decisions

Conduits (partnerships)

• Tax characteristics:– Rate of taxation =– Frequency of taxation =– Deductibility of investment =

• So: what savings vehicle is a partnership like?__________________________

Page 22: Taxes & Investment Decisions

Value to thepartner

NondeductibleInvestment

AnnualTaxation

Ordinarytax rate

Partner’sTax Rate

BTROR for thePartnership

FVpship = I • [1+Rpship • (1-tptr)]n

Page 23: Taxes & Investment Decisions

Entities (corporations)• Tax characteristics of the corporate tax

– Rate of taxation =

– Frequency of taxation =

– Deductibility of investment =

• Tax characteristics of the individual tax when shareholder sells the corporation– Rate of taxation =

– Frequency of taxation =

– Deductibility of investment =

• So: the corporate tax is like…___________________

• So: the individual tax on a sale is like…___________________

Page 24: Taxes & Investment Decisions

Value of theCorporation

to theShareholder

NondeductibleInvestment

Tax-deferred

CGTaxation

• FV = I * [ (1+rcorp)n•(1-g) + g ]

ATROR of the corporation

Page 25: Taxes & Investment Decisions

But: What is rc?

• It is the ATROR from the corporation– After-tax means after the corporate tax, but

before the individual tax

• rc = Rc (1-tc)

CorporateBTROR

CorporateTax Rate

Page 26: Taxes & Investment Decisions

• Now substitute rc into the equation:

• FV = I * { [1+Rcorp• (1-tc)]n•(1-g) + g }

• Therefore, a corporation has the structure of two savings vehicles. It is like...– A cash-producing investment “inside” a

deferred investment with capital gain taxation.

Page 27: Taxes & Investment Decisions

Corporations versus PartnershipsCorporate tax advantages:• Corporation has tax deferral as long as it doesn’t

pay dividends.• Shareholders enjoy no dividend taxation if corporation

distributes profits & 15% capital gains rate if owner sells investment

Corporate tax disadvantage:• Corporate income is taxed twice.Under what conditions would investors be more likely to

prefer corporations?

Page 28: Taxes & Investment Decisions

Insert Entity Planning Example here (Insert #3… file)

Center for International Business Education and Development