Effective Tax Planning

1. Effective Tax Planning • Goal: Maximize the net present-value of after-tax cash flows and cash equivalents

2. Effective Tax Planning continued • 3 Key Considerations: • All costs: Effective tax planning requires the planner to recognize that taxes represent only one among many business costs. In planning all costs must be considered, including the costly restructuring of the business necessary to implement some tax plans • All parties: Effective tax planning us to consider the tax implications of a proposed transaction to all parties to the transaction

3. Effective Tax Planning continued • All taxes: Effective tax planning requires the planner, in making investment and financing decisions, to consider not only explicit taxes (dollars paid directly to tax authorities) but also implicit taxes (taxes paid in the form of lower before-tax rates of return on tax-favored investments)

4. In-Class Problem: Implicit Vs. Explicit Taxes - Municipal Bonds • ALF Corp. is considering investing $100,000 in bonds. It can purchase City of Nashville tax-exempt bonds at a yield of 6%. Assuming that ALF is in a 34% tax bracket, what would a fully taxable bond have to yield to produce an equivalent return? How much implicit tax is paid on the municipal bond investment? • Assume that ALF can invest its $100,000 in City of Nashville bonds or in Togoto Inc. taxable bonds yielding 10%. What is the after-tax return on each investment? Which investment should ALF choose?

5. After-Tax Cash Flows • Receipt of income (generally) subject to tax cost • Income increases cash flow • Tax cost reduces after-tax cash flow • Payment of expenses may be deductible against taxable income, reducing net tax liability by producing a tax benefit • Expense reduces cash flow • Tax benefit increases after-tax cash flow

6. In-Class Problem: Calculating After-tax Cash Flows • Assume Ed earns $10,000 of income and is subject to a 10% tax rate • Calculate the tax cost of the income, and Ed’s after-tax cash flow • If Ed incurs deductible expenses of $4,000 to earn the income, calculate the tax benefit of the deduction, and Ed’s net after-tax cash flow • How would your answer change if the expense is not tax deductible?

7. Net Present Value Analysis • Some assumptions • Cash inflows and outflows associated with decision alternatives can be quantified • Uncertainty as to future cash flows captured using expected values • All cash flows received (paid) at beginning of each year • Year 1 (present) not discounted • Investment risk captured by discount rate and assumed to be stable over time

8. Integrating Taxes into NPV Analysis • Taxes may alter decisions, particularly if: • Tax rates change over time • Different tax treatments apply to transaction alternatives • Sensitivity analysis • Useful for considering the effects of tax law and tax rate uncertainty

9. Parties to the Transaction • Market: a forum for commercial interaction between 2 or more parties to exchange goods or services • Private markets (direct negotiation) offer greatest flexibility in structuring transactions • Public markets offer few opportunities for negotiation, but many alternative investments • Fictitious markets - related parties not negotiating at arm’s length