Income Taxes and Financial Management - Financial Management

A knowledge of tax laws and regulations is essential in making a wide variety of business decisions that affect shareholder wealth, such as what form of business organization to select, what types of securities to issue, and what investment projects to undertake.

Implications of Income Taxes for Financial Managers
Although the effect of income taxes on financial decisions is discussed in detail where appropriate throughout the book, a brief review of some of the critical areas of concern is provided in this section.

Capital Structure Policy

Taxes have important implications for capital structure policy because the interest payment associated with debt financing are deductible from earnings when computing a company’s income tax liability, whereas common stock dividends and preferred stock dividends are not deductible.

In other words, for a company with positive pretax earnings and a 40 percent income tax rate, a new debt issue that increases interest expenses by $1,000,000 per year would cost the company (i.e., reduce after-tax income) only $600,000 —$1,000,000 interest expense less $400,000 tax savings (= .40 _ $1,000,000). This tax advantage of debt is a prime reason for leveraged buyouts and financial restructurings.

Dividend Policy

A firm’s dividend policy may be influenced by personal income taxes. When dividends are paid to common stockholders, these dividends are taxed immediately as income to the shareholder. If, instead of paying dividends, a firm retains and reinvests its earnings, the price of the stock can be expected to increase.

Personal taxes owed on common stock appreciation are deferred until the stock is sold. The ability to defer personal taxes on retained earnings causes some investors (e.g., those in high marginal tax brackets) to prefer retention and reinvestment and ultimately capital gains rather than immediate dividend payments. This investor preference can have an impact on corporate dividend policy, particularly in small, closely held companies.

Capital Budgeting

Capital expenditure decisions are also influenced by corporate income taxes. Capital expenditures require an outlay of after-tax dollars in order to acquire the needed assets. The assets are expected to generate a stream of operating income that is subject to tax. A tax -deductible expense associated with many capital expenditures is depreciation. Depreciation provides a tax deduction equal to a part of the original cost of a depreciable asset, such as machinery or buildings. The tax code details the methods that may be used to depreciate assets.

Because depreciation is a noncash expense (the cash outlay was made when the asset was purchased), it simply reduces taxable income and hence reduces the amount of taxes that must be paid. Changes in the tax code that speed up (slow down) the depreciation rate increase (decrease) the present value of the cash flows from the investment project and make the project a more (less) desirable investment. Therefore, financial managers must pay close attention to expected tax law changes.


The decision to lease or buy an asset is often motivated by its tax effects. If the lessee (asset user) is losing money or not subject to taxation (for example, a nonprofit enterprise), leasing may be advantageous because the lessor (asset owner) can reflect the tax benefits of ownership in the lease rate charged to the lessee.

These and other tax effects of financial decisions will be encountered throughout the text and in the practice of financial management.

Tax Rate Used in the Text

U.S. tax laws impose progressive tax rates on corporate income —the larger the income, the higher the tax rate. during 2004, the largest corporations paid a federal marginal tax rate (i.e., tax rate on the next dollar of income) of 35 percent.

Throughout the text, however,we use an assumed marginal tax rate of 40 percent rather than the actual corporate marginal tax rate of 35 percent. There are two reasons for following this convention. First, it simplifies many of the calculations. Second, most firms are also subject to state -imposed income taxes. A 40 percent rate is an excellent approximation of the combined federal and state income tax rates facing most firms.

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