Ch.

3 Taxes as transaction Costs

Terms:
1. net cash flow: difference between cash received and cash
disbursed.
Managers want to increase revenues and control costs also make
decisions that maximize the value of the firm by maximizing positive
cash flow or minimizing negative cash flow.
2. time value of money: the value of money in terms of time. Money
today is more important that money tomorrow .
-discount rate: after tax rate of interest on invested funds for
the deferral period. The present value of a dollar available in the
future is based on this discount rate
-net present value: sum of the present value of cash inflows and
outflows from the transaction
Net present value: sum of the present value of cash in and outflows
from the transactions.
-present value: PV($1)=1/(1+r)^n, r is the discount rate, and n is the
number of periods over which the discount rate is constant
-annuity: cash flow consisting of a constant dollar amount available at
the end of the period for a specific number of periods.
Ex. Monthly rent payment.
PV ( $1 for n periods)=(1/r)-(1/r(1+r)^n). the formula works only for a
series of equal payments
Compute tax
1. tax costs: additional price you pay on a nontax
cost of an
costs. Ex. Purchase machinery <- inflow, the
income item
sales tax <- outflow
and the tax
ex. Sell inventory for 50, sales transaction
savings from a
generates 10 taxable income, subject ot 30 %
deduction
income tax the tax cost $3. Thus sales
transaction is 50$ cash inflw and $3 cash
outflow.

Integrate tax
costs and
saving into
NPV

2. tax savings: decrease in tax, thus its an inflow.

Taxable incme have have busness expenditures
subtracted. Ex. Spends 1,000 on rent, each
1,000 is deductible the expenditure shields
1,000 income from tax. If 30% tax rate, the
deduction cause 300 tax saving so 1000 outflow
and 300 cash inflow
3. sign of marginal tax rate. Use to calculate
the tax cost or saving from a transaction
Write this out.

calculation
ID the
uncertainties
concerning
future tax
xosts and
savings

Explain wy tax
minimization
may not be
the optimal
business
strategy
Explain why
bilateral tax
planning is
important in
private
market
transactions

Arms-length
vs. related
party
transactions

1. audit risk: didnt calculate properly. Reduce rick

by engaging tax professional or ask IRS ro
analyze proposed transaction which IRS will
communicate back with a private letter ruling
2. tax law uncertainty: tax law change curing NPV
is being calculated
3. Marginal rate uncertainty:
Structing transaction to reduce taxes: change
structure to reduce taxes.
If change saves tax dollars adversely affects other
factors do change the transaction structure. Want to
minimize tax cost as well as maximize net present
value.
-extent managers can control tax consequences of
transaction depends on the hature f the market.
-market: forum for commercial interaction between
two or more arties for the purpose of exchanging
goods or services.
Bilateral planning: because both parties do not
need ot deal with the open market should tailor the
transaction to accommodate for personal needs. Can
work together the minimize aggregate tax
Ex.

Pg 59
Public market transactions: no tailoring ecuase
too large and impersonal, just accept the terms of the
contract. Tax planning is one sided
Arms length: parties deal with their own economic
interests. Parties both benefit from tax consequences
or else wont engage. Unrelated parties.
Related party transactions: between family
members or subsidiary corporation, comparable

interests can accommodate each other. Related party

transaction do not operate under arms length so no
economic interest involved so any tax advantaged
may be taken away.