Taxes & Investment Decisions

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

2. Decision making and taxes: the After-Tax Cash Flow model Framework introduction ATCF model definitions Relation between TI and ATCF ATCF model and rates of return

3. 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--

4. 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?

5. 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

6. BTCF +/- adjustments = Taxable income * Tax rates (t) = Taxes due BTCF - Taxes due ATCF Link Don’t minimize this... ...Maximize this Relation between TI and ATCF Problem with tax minimization strategy: BTCF = f(TI)

7. 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

8. Insert After-Tax Cash Flow example problem here (Insert #1… file) Center for International Business Education and Development

9. Business investment planning Modeling tax characteristics Income-producing investments Equity investments Deferred investments Retirement account investments Relation between different investments Comprehensive examples

10. 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

11. 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

12. 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

13. Cash-producing investments • Rate of taxation = • Frequency of taxation = • Investment deductibility =

14. 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)

15. 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.

16. 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.

17. 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

18. Insert Investment Planning Example Here(Insert #2… file) Center for International Business Education and Development

19. Evaluating Investments in Business Entities Conduits (partnerships) Entities (corporations) Selecting conduit v. entity tax treatment

20. 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.

21. Conduits (partnerships) • Tax characteristics: • Rate of taxation = • Frequency of taxation = • Deductibility of investment = • So: what savings vehicle is a partnership like?__________________________

22. BTROR for thePartnership Partner’sTax Rate FVpship = I • [1+Rpship• (1-tptr)]n Ordinarytax rate AnnualTaxation Value to thepartner NondeductibleInvestment

23. 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…___________________

24. FV = I * [ (1+rcorp)n•(1-g) + g ] CGTaxation ATROR of the corporation Tax-deferred Value of theCorporationto theShareholder NondeductibleInvestment

25. 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) Corporate BTROR Corporate Tax Rate

26. 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.

27. Corporations versus Partnerships Corporate 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?

28. Insert Entity Planning Example here (Insert #3… file) Center for International Business Education and Development