What is the role of government taxes in business case analysis?
When the business case involves a non-profit organization or a government entity that does not pay taxes, the question "What is the role of taxes in the business case?" has a short answer: none. For them, taxes play no role in the business case.
the same question can have different answers, however, when the business case represents tax paying businesses and indiviudals. For tax-paying entities, government taxes sometimes have an important impact on busness case results. Results of "before tax" and "after tax" business cases can look quite different, depending on the scope and purpose of the business case, as explained in the sectionsbelow.
Please see the encyclopedia articale Business Case for an overview of business case analysis scope and purpose, For in-depth spreadsheet examples showing how tax effects enter business case cash flow calculations, see Financial Modeling Pro.)
How do tax consequences impact business case results?
Tax consequences impact projected cash flow summaries and financial metrics for business case scenarios.
- The financial business case for decision support or planning purposes has at its heart a financial model whose purpose is to project (or estimate) cash inflows and cash outflows for a number of cost and benefit items, in one or more scenarios.
- Each scenario represents one decision option or one proposed action.
- In order to evaluate and compare financial results under scenarios, the projected cash inflows and outflows for each scenario are summarized and measured with financial metrics such as net cash flow, discounted cash flow (net present value, or NPV), internal rate of return (IRR), payback period, return on investment (ROI), and others.
- Based on a comparison of financial results and financial metrics from each scenario, the business case analyst may recommend one action or one decision over another.
For more on these points, see the encyclopedia entries for
Tax consequences impact projected cash flow results in the scenario summaries in several ways:
- Taxes lower overall gains.
Where the business case shows gains or net cash inflows, taxes operate to lower overall gains because operating income and capital gains are normally taxed. If the total income tax rate is, say 30%, a $100 operating gain becomes a $70 net gain after taxes.
- Taxes also reduce overall cost and expense impacts.
Where the business case shows losses or net cash outflows, tax effects operate to reduce the overall loss. For a company that pays 30% taxes on income, a $100 operating loss (or net cost) also reduces the company's tax liability by $30. The net effect of the $100 loss on overall cash flow is thus $70.
- When the business case includes the acquisition of capital assets, tax savings from depreciation improve the bottom line.
Tax savings from depreciation can operate to increase overall cash flow. Depreciation expenses themselves do not contribute to cash flow: they are an accounting convention that impacts reported income, but not a real cash outflow. However, because depreciation expenses lower reported income, they also lower the tax liability, which does impact real cash flow.
If a company claims $100 depreciation expense on an asset during the year, and if the company ordinarily pays a 30% tax rate on operating income, then the depreciation expense lowers taxes by $30 (that is, net cash flow for the year is increased by $30).
When should the business case include tax consequences?
Should you build an "after tax" or a "before tax" version of the financial business case? Sometimes one version is more appropriate than the other; in other cases, both versions are called for. To choose an approach for your own business case, address first the following questions:
- Do different proposed actions have different and important tax consequences?
Sometimes, in fact, different actions are proposed and compared because they have different tax consequences. In a "Lease vs. Buy" business case comparison, for instance, one reason for choosing one option (either "Lease" or "Buy") over the other may by that these choices have different tax consequences. Or, the business case evaluating proposed entry into different geographic markets will probably find different tax consequences of doing business in different countries or regions.
- How are other, competing proposals being presented?
In situations where proposals from different sources compete for funding (as in a capital review process), clearly all proposals should be compared on the same basis with respect to tax consequences. As mentioned above, tax impacts lower expected gains and can also lower expected losses (by contributing a tax savings). If these tax impacts are present in one competitor and absent in another, the comparison is not fair.
- Will the subject of the business case likely impact company performance in a way that matters to decision makers and planners?
If the case results are to be used by those who have responsibility for profits/profitability or overall company performance, and if the tax consequences are different under different case scenarios, then an after tax version of the case should certainly be presented.
On the other hand, where conformance to budget or budgetary planning are important considerations, a before tax version of the business case should be included. Managers at some levels of the organization may have much more interest on actual spending levels or sales revenues, and less direct interest in after tax profit levels.