Marginal Tax Rate: Correct Project Cash Flow Evaluation

When we’re thinking about whether a project is a good idea for a company, one of the most important things we look at is the cash flow it’s expected to generate. Cash flow is essentially the money coming in and out of the business because of the project. But it’s not just about the raw numbers. We need to consider how taxes will affect those cash flows. And when we do that, it becomes really important to use the firm’s marginal tax rate, not just any old tax rate.

Think of it like this: imagine your income is taxed in different brackets, like stairs. The first chunk of your income might be taxed at a lower rate, the next chunk at a slightly higher rate, and so on. The marginal tax rate is the tax rate on the next dollar you earn, the rate on the very top step of those income stairs.

Now, when a company takes on a new project, it’s like adding another step to those income stairs, or maybe even building a whole new staircase next to the old one. This project is expected to generate additional income for the company. And this additional income is going to be taxed at the rate that applies to the company’s next dollar of income, which is precisely the marginal tax rate.

Let’s say a company is already quite profitable and falls into a higher tax bracket. Their marginal tax rate might be, for example, 25 percent. If they’re evaluating a new project, the profits from this project will be taxed at this 25 percent rate. It wouldn’t be accurate to use a lower average tax rate, which is simply the company’s total taxes paid divided by their total income. The average rate reflects taxes paid on all their income, including income taxed at potentially lower rates in lower brackets.

Why is this difference so critical? Because when we evaluate a project, we need to figure out the incremental cash flows. Incremental means the extra cash flows that are directly caused by taking on the project. Taxes are definitely an incremental cash flow. If the project generates more profit, the company will pay more in taxes. And the amount of additional tax they pay is determined by the marginal tax rate.

Consider another analogy. Imagine you’re deciding whether to buy an extra cup of coffee. You’re not thinking about the average price you’ve paid for coffee all month. You’re thinking about the price of this next cup of coffee. Similarly, when a company decides on a project, they aren’t concerned with their average tax rate across all existing operations. They are concerned with the tax rate on the additional profits from this specific project.

Using the marginal tax rate ensures we are accurately reflecting the true after-tax cash flows from the project. It correctly captures the tax impact on the change in the company’s income due to the project. This is essential for making sound investment decisions. If we used the average tax rate, we might underestimate or overestimate the actual tax impact of the project, leading to incorrect conclusions about its profitability and whether it should be undertaken.

Think about depreciation, for instance. Depreciation is an accounting expense that reduces taxable income. This reduction in taxable income creates a ‘tax shield’ – it shields some of the company’s income from taxes. The value of this tax shield is directly dependent on the marginal tax rate. The higher the marginal tax rate, the more valuable the tax shield from depreciation becomes. This is because the tax savings from depreciation are calculated by multiplying the depreciation expense by the marginal tax rate.

In essence, evaluating project cash flows is about understanding the financial consequences of a specific decision – whether to invest in this project or not. The marginal tax rate gives us the right tool to measure the tax consequences on the additional income and deductions generated by that decision, ensuring we make informed and financially sound choices for the firm’s future. It’s about focusing on what changes because of the project, and the marginal tax rate precisely captures the tax effect on those changes.