The tax payments represent a cash outflow from the business and therefore, these tax cash flows are critical part of the financial decision making in a business firm. In deed in some practical situations, the taxation implications are dominant influences on the final investment decision also. Taxation effects a firm in numerous ways, the most significant effects are given below:
• Corporate taxes on firm’s profits.
• Reduction in weighted average cost of capital because interest payments are allowable against tax.
• Dividend will not reduce the tax burden of the firm since it is not a charge on profits.
• Where the firm incurs overall loss, it can be carried forward to a future profit making year.
• Where a unit of the firm incurs loss but the firm gets overall profits from all other units, loss of the loss making unit will reduce the overall tax liability of the firm by set off of losses.
• Impact of depreciation provision on the reduction of taxable income.
• Taxation of capital gains and its impact on profits of the firm.
• Double taxation of firm’s earnings like dividends received from other companies and its impact on profits etc.
Financing with debt and making interest payments rather than dividend payments will generate after-tax income for the company’s suppliers of equity capital, but simultaneously there is greater risk associated with financing with debt.
Personal Taxation and its Influence Firm
A business organisation must consider the tax consequences for the investors in company’s shares, debentures and bonds in order to attract investors to the firm’s securities. The investments in company attract two types of taxes to the investors:
• Earnings in the form of dividends and interest.
• Capital gains from disposal of the investments.
When the investments made in tax free securities like Tax free municipal bonds, will not attract any taxation on the individual investors.
Types of Tax Rate
• A progressive tax rate is a rate that escalates as the amount of income increases.
• A marginal tax rate is to be applied to the next rupee of income.
• The average tax rate equals the amount of tax divided by the taxable income.