• Income tax makes a difference in many capital budgeting decisions. The project that is attractive on a before tax basis may have to be rejected on an after tax basis. Income tax typically effect both amount of cash flow and timing of cash flow. Since net income (not cash inflows ) is subjected to tax , after tax cash inflows are not usually same as after tax net income.

  Let us understand with formula :

  S= sales

  E= cash operating expenses

  D= depreciation

  T= tax

  Then before tax cash inflows are: S-E-D

  Now see the cash inflows after tax : (S-E)(1-T)+D(T)

  Some of the items which effect capital budgeting decisions while taking tax into consideration

  DEPRECIATION

  From the above it is observed that deductibility of depreciation from sales is subjected to tax shield , because as per income tax depreciation allowed as deduction form income . so tax on depreciation is the savings from tax payment. the more the depreciation the more the savings from tax payment.

  Let us understand with example:

  S= 10000

  E= 5000

  D=2000

  T=30%

  Now calculate the net operating income before taking tax into consideration

  Net operating income= 10000-5000-2000=3000

  Now calculate the net operating income after taking tax into consideration

  Net operating income=(10000-5000)(1-0.3%)+ tax shield on depreciation

  Tax shield on depreciation is = 2000*30%=600

  So net operating income is =3500+600=4100

  From the above it is observed that after taking tax into consideration net operating income increases by 1100, since depreciation is as expense which is having tax implication as saving so operating income increases by 1100

  INTEREST PAYMENT ON BORROWING

  One of the other items which effect capital budgeting decisions while taking tax into consideration is interest. Interest is a finance expense on which we can gain tax shield at the rate of income tax, so interest expenses will give us tax savings which increases net operating income

  CAPITAL GAIN OR LOSS ON SALES OF FIXED ASSETS

  sale of fixed asset will create capital gain or loss , this gain or loss will have tax implications , If it is gain net operating income will decrease because gain attracts taxes to be paid, if it is loss net operating income will increase because loss gives us tax shield.

  So from the above discussion it can be understand that income tax will effect the capital budgeting decisions

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