LECTUREPEDIA - Ajarn Paul Tanongpol, J.D.; M.B.A.;B.A.; CBEST
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V.

THE EFFECT OF TAX ON CASH FLOW

Future income expected to receive by the investor or firm is known as cash flow. Generally, incomes are taxable. Future income is taxable when it is received. For purposes of our discussion, the following definitions are used:

          = time;

       = net cash income of firm;

        = investment;

      = net cash payment to bondholders;

      = net payment to stockholders;

        = net cash flow of firm;

       = interest payment by firm;

       = all other cash flows;

     = depreciation deduction permitted the firm in period t for tax purposes;

    = Taxes paid by firm: .

            The net cash flow of the firm comes from two sources: stock and bond. The net cash income of the firm is the sum of investment, and the payments to shareholders and bondholders.

                                                                                          [5.1]

By moving investment to the left side of the equation, we get:

Therefore, the total cash flow of the firm is equal to the payments to shareholders and bondholders:

                                                                                                [5.2]

The assumption is that there are two sources of financing for the firm, namely by debt or equity. Equations [5.1] and [5.2] are known as cash inflow cash outflow equations. With the introduction of taxes, the equation [5.1] will be modified:

                                                                               [5.3]

Therefore,

                                                                       [5.4]

Since tax depends on the interest payments on the firm’s debt. Debt here refers to bond. We can now substitute the quantity  with its components and rewrite the equation as:

                                                                     [5.5]

By simplification, the equation becomes:

                                                                       [5.6]

            There is always a contravening effect between stockholders’ and bondholders’ interests. If there is an increase in payment to bondholders, dividends payment to shareholders will be reduced.

, or

                                                       [5.7]

            Throughout this introductory discussion, we do not use the symbol tildes (~) above the variables. The tilde is used to signify uncertainty. This section of our discussion talks about cash flow in general, and does not go into details about the certainty or uncertainty of the cash flow. The effect of corporate tax on the firm’s cash flow is that the amount of taxable income is reduced as the net amount of Y.

            There are three components of the equation that reduces the firm’s income tax liability: investment, depreciation, and interest payment. These three elements are the common factors that effectively reduce the firm’s tax liability. The corporate tax structure is pro-business because all investment made by the firm is allowed as tax deductions. Similarly, the tax structure also favors firm’s expenditure on asset acquisition. All assets acquired by the firm are allowed to be depreciated and offset against the firm’s taxable income. Lastly, firms are encouraged to borrow money to expand or carry on its operations by allowing the firm to deduct all debt service requirements.

Last modified: 11/11/08