Chap 3 - Other Tax Issues Flashcards
Martin & Sons is seeking tax advice from the company’s CPA regarding a possible investment in a new production facility. Which of the following statements is likely to be good advice for the company?
a. Asset sales from the old facility may result in a loss on sale, and the tax effect will be treated as an increase in the recorded amount of the new investment.
b. Asset abandonments from the old production facility will not have a tax effect because those assets were purchased in the past, and are almost fully depreciated.
c. Asset purchases for the new facility will be analyzed in light of future pretax cash flows.
d. Asset trade-ins could result in lower taxes payable in later years.
Asset trade-ins could result in lower taxes payable in later years.
Choice “d” is correct. Generally, no gain or loss is recognized on the trade-in of an old asset for tax purposes; hence, there is no tax effect. The traded-in asset’s book value becomes a portion of the depreciable basis of the new asset, resulting in additional depreciation for tax purposes in later years and the reduction of taxes payable in those later years. Therefore, the cash outflows in later years will decline.
Choice “b” is incorrect. If an asset is abandoned, the net salvage value is treated as a reduction of the initial investment in the new asset. The abandoned asset’s book value is considered a sunk cost, and therefore not relevant to the decision-making process. The remaining book value (for tax purposes) is deductible as a tax loss, which reduces the liability in the year of abandonment. This tax liability is considered a reduction of the new asset’s initial investment in capital budgeting.
Choice “c” is incorrect. Financial models used for capital decisions focus the financial manager on the cash flows associated with the investment and the comparison of those cash flows to expected rates and amounts of return. Because income taxes are a significant cash flow, they are considered in capital investment decisions, so the cash flows used are after-tax cash flows, not pretax cash flows.
Choice “a” is incorrect. The amount of income tax paid on a gain on a sale is treated as a reduction of the sales price (which increases the initial expenditure). Conversely, a reduction in tax resulting from a loss on sale is treated as a reduction of the new investment.
How are after tax cash flows computed?
The tax savings or expense related to a particular cash flow equals the amount of the expense or income times the marginal income tax rate of the firm. This amount is deducted form cash flows to determine the after tax amount of the cash flows.
After tax cash flows = pretax cash flows x ( 1 - tax rate)
Which types of asset transactions affect income taxes and cash flows?
- Asset abandonment
- Asset Sale
- Asset trade-in
What is the tax treatment for an abandoned asset?
The remaining book value is deductible as a tax loss for tax purposes. The tax loss will reduce tax liability int he year of abandonment.
How are income taxes/cash flows affected by an asset trade in?
Generally, no gain or loss is recognized on the trade in of an old asset for tax purposes, therefore there is no immediate tax effect. The traded in assets book value becomes a portion of the depreciable basis of the new asset, resulting in additional depreciation for tax purposes in later years and the reduction of taxes payable in those later years.
