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# How Taxes Impact Your Investments

http://www.fool.com/investing/general/2012/12/10/how-taxes-impact-your-investments.aspx

Travis Hoium
December 10, 2012

The negotiations over the fiscal cliff are constantly going back and forth, and one of the thorny issues, as usual, is taxes. President Obama wants to raise rates and the GOP wants to cut loopholes and reduce deductions to raise revenue.

I'm not here to debate the merits of either plan from a political standpoint, as The Motley Fool isn't the forum for that kind of political debate. What does matter is how tax rates impact businesses and by extension our investment profits. Warren Buffett has famously said that he doesn't know a single business owner who has made an investment decision based on tax rates, something that some have refuted, but since he is Warren Buffett, his words have weight in the debate.

So do tax rates matter? And if so, to whom?

I'll try to break it down from a mathematical standpoint and point out the rates that matter to businesses and investors and how it will affect the market going forward.

When a company is considering an investment like a piece of equipment or an R&D project, its financial analysts create a model to weigh the outcomes. These models include outflows of cash to make the investment and inflows of cash that are the return on that investment. Whenever there's an inflow of cash, taxes matter, which is why rates matter to this analysis.

The rate that companies pay or use in models may change based on location, business type, or any number of factors. But the basic premise is the same: Taxes are part of the equation.

So, let's do a very simplified financial analysis of a hypothetical project and see what taxes do to its return. I've laid out the assumptions below, including 0% inflation and 0% growth initially. We'll assume that there's a one-time cash outflow of \$100,000 today (for example, to buy equipment) and that the investment will create cash flows for 10 years in equal amounts starting one year from today before becoming obsolete.

 Capital outlay today \$100,000 Required return on capital / discount rate 10% Years the project will produce revenue 10 Earnings before taxes and depreciation expected per year \$19,653 Tax rate 35% Net income per year \$16,275 Rate of return 10%

Source: Author's calculations. Assumes straight-line depreciation allowance for tax purposes.

If we calculate a rate of return, or IRR, for this project, we find that the return is exactly 10%. Based on the cost of capital of 10% in this company, it would be wise to pursue this project because the return on investment is exactly the cost of capital. Notice that I have not included revenue, margins, or other items; these don't matter to the investment thesis as long as we know pre-tax profit and include any other investments in our initial capital outlay number.

Now if we do the exact same project and only change the tax rate, the dynamic changes.

30% Tax Rate

35% Tax Rate

40% Tax Rate

Pre-tax profit/yr

\$19,653

\$19,653

\$19,653

Taxes

\$2,896

\$3,378

\$3,861

Net income/yr

\$16,751

\$16,275

\$15.792

Return on investment

10.7%

10%

9.3%

Source: Author's calculations.

Based on this table, tax rates make all the difference in the world when deciding if this project is worthwhile. If rates are 35% or below, we would go forward; if they are higher, we wouldn't.

Other important factors
So, if tax rates are so important to businesses and investors, why has fellow Fool Morgan Housel concluded that tax rates have little correlation to GDP growth? Logic should tell us that lower tax rates will always lead to higher return for investors/businesses and therefore more investments by investors/businesses.

The easy answer is that growth often has the largest effect on most financial models. A 2% change in the growth rate has an even greater effect than a 5% change in the tax rate. Here is the same ROI calculation just like I did above except I've modeled three different growth rates (still 0% inflation).

30% Tax Rate

35% Tax Rate

40% Tax Rate

0% growth

10.7%