Narrator: Welcome to financial management. To begin, let s work some problems related to corporate taxes.

Transcription

1 MGT 325: Module 1 AVP Transcript Title: Tax Effects Slide 1 Title Slide Narrator: Welcome to financial management. To begin, let s work some problems related to corporate taxes. Slide 2 Title: Corporate Tax Rate Schedule Over $18,333,333 $6,416, % X amount over $18,333,333 Narrator: We will use this Corporate Tax Rate Schedule to work many of the problems in this example. Slide 3 c. What was the firm s average tax rate? 19,700 $92,500 = 21.3% d. What is the firm s marginal tax rate? 34% Narrator: This firm s earnings before taxes are $92,500. Slide 4

2 Over $18,333,333 $6,416, % X amount over $18,333,333 (Note: Row 5 is highlighted in yellow.) Narrator: In the Corporate Tax Rate Schedule, we see that this puts it in the range of taxable income of $75,000 to $100,000. Therefore, we should use the tax calculations from the third row of the table to calculate the firm s tax liability. Slide 5 Narrator: We take the base tax of $13,750 and add it to the marginal rate of 34% times the earnings over the base rate of $75,000. We calculate the earnings over the base rate by subtracting $75,000 from $92,500. This gives us our tax liability of $19,700. Slide 6 Narrator: We then calculate the after-tax earnings by subtracting the tax liability of $19,700 from the before tax earnings of $92,500. This gives us our after-tax earnings of $72,800. Slide 7

3 c. What was the firm s average tax rate? 19,700 $92,500 = 21.3% Narrator: The average tax rate is the average tax paid by the firm on every dollar earned. The firm s average tax rate of 21.3% is calculated by dividing the firm s tax liability of $19,700 by its before tax earnings of $92,500. Slide 8 c. What was the firm s average tax rate? 19,700 $92,500 = 21.3% d. What is the firm s marginal tax rate? 34% (Note: Column E is highlighted in yellow.) Narrator: The firm s marginal tax rate of 34% was shown in this table. The marginal tax rate represents the rate at which the next dollar of income is taxed. In most business decisions that managers make, the marginal tax rate is the rate that really matters. Slide 9 Title: Average Corporate Tax Rates Using the Corporate Tax Rate Schedule, find the tax liability, after-tax earnings, and average tax rate for a firm with corporate earnings before taxes of $80,000 and for a firm with corporate earnings before taxes of $20,000,000.

4 Over $18,333,333 $6,416, % X amount over $18,333,333 (Note: Rows 5 and 10 are highlighted in yellow.) Narrator: Let s solve another problem. The first firm s earnings before taxes are $80,000, and the second firm s earnings before taxes are $20,000,000. In the Corporate Tax Rate Schedule, we see that this puts the first firm it in the range of taxable income of $75,000 to $100,000, and the second firm in the last row. Slide 10 Title: Average Corporate Tax Rates Using the Corporate Tax Rate Schedule, find the tax liability, after-tax earnings, and average tax rate for a firm with corporate earnings before taxes of $80,000 and for a firm with corporate earnings before taxes of $20,000,000. $80,000: Tax = $13,750 + [0.34 (80,000 $75,000)] = $15,450 After-tax earnings: $80,000 $15,450 = $64,550 Average tax rate: $15,450 $80,000 = 19.3% Narrator: We take the base tax of $13,750 and add it to the marginal rate of 34% times the earnings over the base rate of $75,000. This gives us our tax liability of $15,450. We then calculate the after-tax earnings by subtracting the tax liability of $15,450 from the before tax earnings of $80,000. This gives us after-tax earnings of $64,550. The firm s average tax rate of 19.3% is calculated by dividing the firm s tax liability of $15,450 by its before tax earnings of $80,000. Slide 11 Title: Average Corporate Tax Rates Using the Corporate Tax Rate Schedule, find the tax liability, after-tax earnings, and average tax rate for a firm with corporate earnings before taxes of $80,000 and for a firm with corporate earnings before taxes of $20,000,000. $80,000: Tax = $13,750 + [0.34 (80,000 $75,000)] = $15,450 After-tax earnings: $80,000 $15,450 = $64,550 Average tax rate: $15,450 $80,000 = 19.3% $20,000,000: Tax = $6,416,667 + [0.35 ($20,000,000 $18,333,333)] Tax = $7,000,000 After-tax earnings: $20,000,000 $7,000,000 = $13,000,000 Average tax rate: $7,000,000 $20,000,000 = 35% Narrator: These are the calculations for the second firm. Remember, we use the last row of the Corporate Tax Rate Schedule for the tax information. This problem demonstrates that the average tax rate tends to go up as a firm earns higher profits. Slide 12

5 Title: Marginal Corporate Tax Rates Using the Corporate Tax Rate Schedule, find the marginal tax rate for firms with corporate earnings before taxes of $60,000; $90,000; and $200,000. Tax Calculation Pre-tax Base Amount Total Marginal + % = Income Tax over Base Tax Rate 60,000 7,500 ( ,000) 10, % 90,000 13,750 ( ,000) 18, % 200,000 22,250 ( ,000) 61, % Corporate Tax Rate Schedule Over $18,333,333 $6,416, % X amount over $18,333,333 (Note: Rows 5-7 are highlighted in yellow; Cells E2 and E4:E7 are highlighted in orange.) Narrator: The marginal tax rate is found by determining which range of taxable income the firm falls in on the Corporate Tax Rate Schedule. These three firms fall in the $50,000 to $75,000 range; $75,000 to $100,000 range; and $100,000 to $335,000 range respectively. The marginal tax rates are shown in the table. They are 25%, 34%, and 39% respectively. Remember that the marginal rate is usually the rate that matters in financial decision making because this is the rate the firm will pay on the next dollar earned. Slide 13 Title: Interest versus Dividend Income A firm in the 40% tax bracket has pretax earnings from operations of $490,000, received $20,000 in bond interest income and $20,000 in stock dividends. Find the tax on operating earnings and the tax and aftertax income attributable to the interest and dividend income. Operating earnings tax: $490, tax rate = $196,000 Interest Income Dividend Income Before-tax amount $20,000 $20,000 Less: Applicable exclusion 0 14,000 (0.70 $20,000) Taxable amount 20,000 6,000 Tax (40%) 8,000 2,400 After-tax amount 12,000 17,600

6 Narrator: In this problem, we see that operating earnings are taxed at the corporate tax rate of 40%. This results in a tax liability of $196,000. The interest income is also taxed at the full 40% rate. This results in a $8,000 tax and $12,000 of after-tax earnings for the bond interest. According to the tax code, 70% of the dividend income to corporations is not taxed. Therefore, the firm is only paying taxes on $6,000 of the dividend income. This results in a $2,400 tax and $17,600 of after-tax earnings for the dividend income. All else being equal, the firm would rather receive dividend income than interest income. This 70% exclusion seems like a huge tax loophole for corporations but that is not actually the case. The firm paying the dividend has already paid taxes on the income it is using to pay the dividend to the second corporation. Therefore the taxes that the second corporation is paying on 30% of the dividends received is the second time those initial profits have been taxed. If the second corporation decides to pay those dividends received out to its shareholders, the profits will be taxed a third time at the individual shareholders rates. Triple taxation of corporate profits can and does occur under the United States tax code. Slide 14 Title: Interest versus Dividend Expense A corporation has earnings before interest and taxes (EBIT) of $40,000 and a tax rate of 40%. Compute the firm s earnings after taxes and earnings available for common stockholders if: a) the firm pays $10,000 in interest or b) the firm pays $10,000 in preferred stock dividends. a. EBIT $40,000 Less: Interest expense 10,000 Earnings before taxes $30,000 Less: Taxes (40%) 12,000 Earnings after taxes* $18,000 b. EBIT $40,000 Less: Taxes (40%) 16,000 Earnings after taxes $24,000 Less: Preferred dividends 10,000 Earnings available for common stockholders $14,000 * This is also earnings available to common stockholders. Narrator: Corporations can deduct interest expense from income. Corporations cannot deduct common or preferred stock dividends from income. Thus, the United States tax code encourages firms to take on more debt. There are good reasons for this because debt can be used to increase economic growth, but it does encourage corporations to take on more risk with the debt which can have negative consequences. In this problem, when the firm pays $10,000 in interest, it deducts that interest expense from its Earnings Before Interest in Taxes resulting in earnings before taxes of $30,000, a tax bill of $12,000, and earnings after taxes of $18,000. The earnings available to common stockholders are also $18,000. If the firm instead pays $10,000 in preferred stock dividends, then that payment is not tax deductible. This results in a higher tax bill of $16,000 and earnings after taxes of $24,000. Still, the firm must then pay the preferred dividends resulting in only $14,000 available to common stockholders.

7 Most firms prefer to use bonds over preferred stock to raise funds because the interest payments on bonds is tax deductible but the dividends paid on preferred stock are not. Therefore, using bonds to raise funds will result in more earnings available to common stockholders, and common stockholders are the true owners of the firm. Slide 15 Title: Capital Gains Taxes A company is selling an asset for $35,000 that was previously purchased for $30,000. The firm is subject to a 40% tax rate on capital gains. Calculate the amount of capital gain, if any, realized on the sale and the applicable tax. Capital gain = $35,000 $30,000 = $5,000 Capital gain tax = $5, = $2,000 Narrator: When a firm has a gain, it must pay a capital gains tax on the profit from the sale. In this case, the gain is $5,000 and the tax is 40% of the gain or $2,000. Slide 16 End of presentation.