AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 Chapter 14, Module 6 Slide 1 AMIS 212Introductory Managerial AccountingProfessor Marc SmithCHAPTER 1 MODULE 1Chapter 14 Module 6 Hi everyone welcome back! In this module I’d like to look at the net present value calculation a little bit more in depth and incorporate how we deal with the NPV when we introduce income tax effects. Now please go to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 Slide 2 A cash flow net of its income tax effect is known as an after-tax cash flow.To calculate an after-tax cash flow, use the following equation:Chapter 14 Module 6: After-Tax Cash FlowsAfter-tax cash flow= Tax effect × Amount of cash flow Let’s get started. A cash flow that is net of its income tax effect is called an after-tax cash flow. And to calculate the after-tax cash flow you simply take the cash effect of the cash flow and multiply by the amount of the cash flow. That gives me my after-tax cash flow. Let’s see if we can illustrate this, go to the next slide.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 Slide 3 Assume a company with a 30% tax rate is contemplating investing in a training program that will cost $60,000 per year.The training program is an expense which reduces the company’s net income. By reducing net income, it also reduces the amount of income taxes the company owes.Cost of training program = 60,000Tax savings due to deductible expense = 18,000 (60,000 x 30%)After-tax cost of training program = 60,000 - 18,000 = 42,000Chapter 14 Module 6: After-Tax Cash Flows And let me see if I can make up a basic example. Let’s assume that a company that has a 30% tax rate is considering investing in a training program that will cost $60,000 per year. Now this training program, while it will cost us $60,000, is also an expense and because it is an expense it will reduce the company’s net income and because it reduces the company’s net income it also will reduce the amount of income taxes the company has to pay to the government. So there is actually a bit of a tax savings here. There is a bit of a cash inflow coming from the fact that we have to pay less in taxes because we have this deductable expense. Just to illustrate how this is going to play out, we know that the cost of the training is going to be $60,000 but because it is an expense it also reduces our income and allows us to save in taxes.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 So the tax savings due to having this deductable expense is $18,000, the $60,000 cost times the 30% tax rate. So the after-tax cash flow, the after-tax cost of the training program, well the $60,000 cost we’re going to have to spend minus the $18,000 savings in taxes so the after-tax cost is $42,000. Now if you’ll go to the next slide with me. Slide 4 Typical Cash Outflows – After Tax1) Initial Investment x 1 (no tax effect)2) Working capital needed now x 13) Increase in costs x (1 – tax rate)4) Repairs, maintenance, overhauls x(1 – tax rate)Chapter 14 Module 6: After-Tax Cash Flows One of the things we’re going to have to be able to do is take those lists that we saw a few modules ago where we listed out the inflows and the outflows and adjust each of them for their tax effects. So let’s create 2 new lists, 2 lists inflows and outflows but this one will be net after-tax. Let’s start with the outflows. And we know the typical cash outflows we saw a few modules ago, the initial investment.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 To adjust it for taxes multiply by 1. We’re not going to change it because the initial investment has no tax effect. The working capital needed now also has no tax effect so multiply it by 1 as well. Any increase in costs, well there is a tax effect there, to adjust it to come up with the after-tax cash flow multiply it by 1 minus the tax rate. Same thing for repairs, maintenance, and overhauls, multiply those by 1 minus the tax rate to adjust for taxes. Question, why in the world would the initial investment not have a tax effect? Let’s go to the next slide and answer that. Slide 5 Question: Why is there no tax effect on the initialinvestment?Answer: The initial investment does not effectrevenues or expenses thus it doesnot effect the taxes owed by a company.The initial investment is simply givingup cash (an asset) to purchase anotherasset (equipment; machinery).The same logic can be applied to theworking capital which is why there isno tax effect on it as well.Chapter 14 Module 6: After-Tax Cash Flows So why is there no tax effect on the initial investment?AMIS 212: Introductory Managerial Accounting Chapter 14, Module 6 AMIS 212 – Professor Marc Smith Chapter 14, Module 6 Why are we simply multiplying it by 1? Meaning we’re not changing at all, we’re not adjusting it for taxes. Well the answer is your initial investment doesn’t affect your revenues or expenses. There is no effect on revenues; no effect on expenses from the initial investment and by not affecting revenues or expenses there’s no effect on income. And because there is no effect on income, there is no effect on income taxes. So the initial investment which is simply swapping out one asset for another, we’re giving up cash, an asset, to purchase equipment or machinery, another asset. No effect on the income statement so