I think this is kinda a basic theory, but for some reason I cannot get my head around it.
When an item/expense on the income statement is stated as tax deductible, what does this really mean? I know to some extent that it means reducing the company’s final tax bill, but how does the accounting work?
From a tax perspective, the tax deductible item doesn’t exist. So if I have gross income of $100, my tax rate is 20%, and $20 of my income is deductible, I pay taxes of $80*20% = $16.
That part I more or less understand.
One example of what I don’t understand regarding tax deductibility is capital raising. Between the issuance of bonds and equity, bonds are picked as the better case in most cases because the interest payment on the bonds are tax deductible. What does this really mean?
That’s due to interest expense. If you borrow $100 and pay 1% interest, you get to deduct $1 from your income statement for tax purposes.
But doesn’t that make every other pre-expenses as tax deductible? like if we have $100 in revenue and $50 of COGS, can we also say that the COGS is tax deductible since it reduces the net income by $50?
Yes you can, but your statement is not entirely correct. $50 of COGS does not reduce net income by $50. Rather, it reduces it by 1-T.
Wow, I have struggled with a bit of this myself. When calculating FCFF the (first half) of the formula form NI is
NI+DEP+Int(1-T)
So, based on Hank’s comment above it makes since why it would be Int(1-T). Dep logicaly gets added back since its a non cash charge but doen’t depreciation reduce the tax expense? So wouldn’t your FCFF include Dep AND Dep(T)?
Referring to your question: “So wouldn’t your FCFF include Dep(1 - T) AND Dep(T)?” Yes, the full Dep is added back to NI. Cashflow is reduced by the level of depreciation, so needs to be added back to NI.
So why does the same logic not apply to Int?
Your question is so interesting that makes me restudy FCFF syllabus, Thecodont. This proves my study is not deep and focus-on-understanding enough. I have been just reading and turning pages.
Anyway, I found the answer to your question in the CFA II Syllabus in equity volume. Turn to page 281, look at the ending sentence of the 2nd paragraph, and also read the notes down below the page. You will see that the use of after-tax interest expense in the FCFF calculation is explained so differently from what is discussed in this thread. It relates to the use of after-tax WACC.
Take a look there. Hope your question will be answered satisfactorily.
Roger.
Thecodont, the difference is that interest exp is a cash expense while depreciation is not.
You are correct. Essentially depreciation/amortization you can think of getting the total amount back (added back to arrive at FCFF) and a bonus which is related/equal to its taxable amount. So yes, you get Dep + (Dep x T) essentially.
Interest on the other hand is being added back not becuase it’s a noncash expense but bc we are trying to get to FCFF (total debt and equity), so we are only adding back the piece of int exp that is essentially missing which is Int (1-T). This we subtract out later to arrive at FCFE. Because interest is a cash expense, the only benefit you receive is (Int Exp x T), not this plus all of interest like was the case with depreciation.
That’s about as clear as mud, but hopefully that helps somewhat.