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After-tax Project Irr, Interest Consideration In Calculation Of Income Tax

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After-tax Project Irr, Interest Consideration In Calculation Of Income Tax

Postby Ridge » Wed Nov 16, 2016 6:48 am

Dear Warren Miller,    I understand that in calculation of PROJECT IRR, the loan interest shall not be considered as a cash outflow. However, if the project IRR here is after tax(i.e. after income tax), I would like to know how to deal with the income tax for calculation of Project IRR. There are two methods to deal with the income tax:(1) the interest is deducted,(2) the interest is not considered. In my opinion, the calculation of project IRR shall be irrespective of financial resources, i.e. all investment capitals shall be considered as the equity, even if some money is borrowed from the bank. Therefore, I think that for the after-tax project IRR, the interest should not be considered in the calculation of income tax, as any factor related to financing should be excluded. In comparision, in normal accounting practice, the loan interest is deducted in the calculation of income tax)

I am looking forward to your opinion as soon as you can. Thank you very much.

Best wishes,

Tang chunchao

ANSWER: Hi, Tang Chunchao--

It's nice to hear from you and to revisit the question of Interest Expense in IRR yet again. If you search around in previous posts, you'll see that I have commented on this before. See 7/25/08("IRR").

Let me tell you, though, you're on a good track here, Chunchao. The interest deduction is about ACCOUNTING, not ECONOMICS. Capital budgeting is about economics. Therefore, the source of the financing doesn't matter. What you want to focus on is the economics of the project on a stand-alone basis independent of the financing source(s). Therefore, omitting interest expense is correct. You're absolutely right.

Please do me a favor by completing the rate-the-expert e-mail you'll receive about the same time you get this reply from me. Your ratings and, especially, your comments help me do a better job of helping folks like you who ask such interesting questions!

Hope I've been helpful here. Thanks for writing, and don't hesitate to do so again anytime.

Best regards--

Warren

---------- FOLLOW-UP ----------

Dear Warren,

Thank you very much for your comments. I absolutely agree with you. However, somebody argues that the project IRR calculation shall be based on actual cash flows, therefore the interest expense shall be deducted in the calculation of income tax as it actually flows out(payable).  

I would like to know if there is any authoritative literature in the worldwide demonstrating that the project IRR calculation is not necessarily based on actual cash flows as the interest deduction in the calculation of income tax is about ACCOUNTING, not ECONOMICS.

Thanks again.

Best regards

Tang ANSWER: Hi, Tang--

I guess the answer to your question depends on how one defines "authoritative literature." Here's a quotation from "Capital Investment and Valuation" by Richard A. Brealey & Stewart C. Myers(New York: McGraw-Hill, 2003); Brealey & Myers are the co-authors of the best-selling finance textbooks used in undergraduate and graduate courses. Here's an excerpt from p. 110 in that book:

"[Analyzing a project] takes no notice of how that project is financed. It may be that [a company] would decide to finance partly by debt, but if it did, we would NOT [CAPS added, Tang] subtract the debt proceeds from the required investment, nor would we recognize interest and principal payments as cash outflows. We would treat the project as if it were all equity-financed, treating all cash outflows as coming from stockholders and all cash inflows as going to them. We approach the problem in this way so that we can separate the analysis of the investment decision from the financing decision."

In "Finance for Executives: Managing for Value Creation [2nd Ed.]" by Gabriel Hawawini & Gabriel Viallet(Cincinnati, Ohio: South-Western Publishing, 2002), p. 399, is this:

"[T]he relevant tax expense must be taken BEFORE [CAPS added - original text is italicized] interest costs, because the cash flow from assets must exclude any item related to the firm's financing policy. If TC is the firm's corporate tax rate, the relevant tax expense is TC multiplied by EBIT because EBIT is earnings BEFORE [italicized] interest and taxes."

As I asked previously, Tang, please do me a favor by completing the rate-the-expert e-mail you'll receive about the same time you get this reply from me. Your ratings and, especially, your comments help me do a better job of helping folks like you who ask such interesting questions.

Hope I've been helpful here. Thanks for your questions. Please don't hesitate to post again anytime.

Best regards--

Warren

---------- FOLLOW-UP ----------

Dear Warren,

Thank you very much for your quick response. I am now bothering you for more details. Is there a consensus in academic society on how to deal with the interest in the calculation of income tax for after-tax PROJECT IRR(Total Investment IRR)? In other words, if it is an international practice that the interest is omitted in the calculation of income tax to avoid financing effects on the analysis of the investment decision. Is there any more convincing evidence(literatures are preferable) demonstrating that the interest shall be omitted in the calculation of income tax, even though in accounting practice the interest can be deducted in the calculation of income tax according to a country’s Law of Tax.

Thanks again!

Best regards

Tang
Ridge
 
Posts: 40
Joined: Sat Feb 01, 2014 3:09 am

After-tax Project Irr, Interest Consideration In Calculation Of Income Tax

Postby Wesley » Fri Nov 18, 2016 1:28 am

Tang, you have crossed the line from a student needing information into PAID CONSULTING work. You are obviously well-informed. At first, I couldn't tell if you were a student or a well-paid professional. I have now concluded that you are the latter. That means that you're "free-riding" here, and I don't tolerate free riders.

If you would like to discuss a for-pay professional arrangement, please e-mail me @ [email protected] I will tell you in advance, however, that(a) I work ONLY under retainer agreements(i.e., pay-in-advance) and(b) the retainer I require is high. If you and your employer find those conditions acceptable, perhaps we can work something out. If not, then I think you have abused the AllExperts.com process quite enough. I'm willing to help people who are studying and/or who are trying to learn, NOT business professionals who are either themselves too cheap to pay for expert advice or work for an employer that is borderline crooked.

WDM
Wesley
 
Posts: 32
Joined: Fri Apr 18, 2014 9:52 am

After-tax Project Irr, Interest Consideration In Calculation Of Income Tax

Postby Gerred » Tue Nov 22, 2016 1:23 am

Dear Warren Miller,    I understand that in calculation of PROJECT IRR, the loan interest shall not be considered as a cash outflow. However, if the project IRR here is after tax(i.e. after income tax), I would like to know how to deal with the income tax for calculation of Project IRR. There are two methods to deal with the income tax:(1) the interest is deducted,(2) the interest is not considered. In my opinion, the calculation of project IRR shall be irrespective of financial resources, i.e. all investment capitals shall be considered as the equity, even if some money is borrowed from the bank. Therefore, I think that for the after-tax project IRR, the interest should not be considered in the calculation of income tax, as any factor related to financing should be excluded. In comparision, in normal accounting practice, the loan interest is deducted in the calculation of income tax)

I am looking forward to your opinion as soon as you can. Thank you very much.

Best wishes,

Tang chunchao

ANSWER: Hi, Tang Chunchao--

It's nice to hear from you and to revisit the question of Interest Expense in IRR yet again. If you search around in previous posts, you'll see that I have commented on this before. See 7/25/08("IRR").

Let me tell you, though, you're on a good track here, Chunchao. The interest deduction is about ACCOUNTING, not ECONOMICS. Capital budgeting is about economics. Therefore, the source of the financing doesn't matter. What you want to focus on is the economics of the project on a stand-alone basis independent of the financing source(s). Therefore, omitting interest expense is correct. You're absolutely right.

Please do me a favor by completing the rate-the-expert e-mail you'll receive about the same time you get this reply from me. Your ratings and, especially, your comments help me do a better job of helping folks like you who ask such interesting questions!

Hope I've been helpful here. Thanks for writing, and don't hesitate to do so again anytime.

Best regards--

Warren

---------- FOLLOW-UP ----------

Dear Warren,

Thank you very much for your comments. I absolutely agree with you. However, somebody argues that the project IRR calculation shall be based on actual cash flows, therefore the interest expense shall be deducted in the calculation of income tax as it actually flows out(payable).  

I would like to know if there is any authoritative literature in the worldwide demonstrating that the project IRR calculation is not necessarily based on actual cash flows as the interest deduction in the calculation of income tax is about ACCOUNTING, not ECONOMICS.

Thanks again.

Best regards

Tang ANSWER: Hi, Tang--

I guess the answer to your question depends on how one defines "authoritative literature." Here's a quotation from "Capital Investment and Valuation" by Richard A. Brealey & Stewart C. Myers(New York: McGraw-Hill, 2003); Brealey & Myers are the co-authors of the best-selling finance textbooks used in undergraduate and graduate courses. Here's an excerpt from p. 110 in that book:

"[Analyzing a project] takes no notice of how that project is financed. It may be that [a company] would decide to finance partly by debt, but if it did, we would NOT [CAPS added, Tang] subtract the debt proceeds from the required investment, nor would we recognize interest and principal payments as cash outflows. We would treat the project as if it were all equity-financed, treating all cash outflows as coming from stockholders and all cash inflows as going to them. We approach the problem in this way so that we can separate the analysis of the investment decision from the financing decision."

In "Finance for Executives: Managing for Value Creation [2nd Ed.]" by Gabriel Hawawini & Gabriel Viallet(Cincinnati, Ohio: South-Western Publishing, 2002), p. 399, is this:

"[T]he relevant tax expense must be taken BEFORE [CAPS added - original text is italicized] interest costs, because the cash flow from assets must exclude any item related to the firm's financing policy. If TC is the firm's corporate tax rate, the relevant tax expense is TC multiplied by EBIT because EBIT is earnings BEFORE [italicized] interest and taxes."

As I asked previously, Tang, please do me a favor by completing the rate-the-expert e-mail you'll receive about the same time you get this reply from me. Your ratings and, especially, your comments help me do a better job of helping folks like you who ask such interesting questions.

Hope I've been helpful here. Thanks for your questions. Please don't hesitate to post again anytime.

Best regards--

Warren

---------- FOLLOW-UP ----------

Dear Warren,

Thank you very much for your quick response. I am now bothering you for more details. Is there a consensus in academic society on how to deal with the interest in the calculation of income tax for after-tax PROJECT IRR(Total Investment IRR)? In other words, if it is an international practice that the interest is omitted in the calculation of income tax to avoid financing effects on the analysis of the investment decision. Is there any more convincing evidence(literatures are preferable) demonstrating that the interest shall be omitted in the calculation of income tax, even though in accounting practice the interest can be deducted in the calculation of income tax according to a country’s Law of Tax.

Thanks again!

Best regards

Tang
Gerred
 
Posts: 57
Joined: Wed Jan 01, 2014 2:20 pm


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