The Net Present Value Effective Tax Rate

21 Pages Posted: 5 Aug 2011

See all articles by Jim Musumeci

Jim Musumeci

Southern Illinois University - Department of Finance

Richard C. Sansing

Tuck School of Business at Dartmouth

Multiple version iconThere are 2 versions of this paper

Date Written: June 2011

Abstract

This study reexamines two common measures of the effective tax rate on a marginal project that generates positive cash flows early in its life and negative cash flows late in its life. The long-run average accounting effective tax rate, which compares the ratio of tax expense to pretax accounting earnings over the life of the project, can be misleading because it does not adjust for the time value of money, thereby overweighting the effects of future cash flows. The economic effective tax rate on the project, which compares the project’s pretax and after-tax internal rates of return, can yield multiple or economically meaningless solutions. In addition, it can misleading because the pretax internal rate of return discounts future cash flows at a rate other than the project’s cost of capital. We characterize a new effective tax rate measure based on net present values rather than internal rates of return or accounting earnings. Our measure indicates that projects with long-run negative cash flows are tax-disfavored, because the present value of the project’s future cash flows decays more rapidly than the value of the asset that generates revenue.

Keywords: effective tax rate, tax preferences, internal rate of return, net present value

JEL Classification: H25

Suggested Citation

Musumeci, Jim and Sansing, Richard C., The Net Present Value Effective Tax Rate (June 2011). 2011 American Accounting Association Annual Meeting - Tax Concurrent Sessions , Available at SSRN: https://ssrn.com/abstract=1904917 or http://dx.doi.org/10.2139/ssrn.1904917

Jim Musumeci

Southern Illinois University - Department of Finance ( email )

Mailcode 4626
Carbondale, IL 62901-4626
United States

Richard C. Sansing (Contact Author)

Tuck School of Business at Dartmouth ( email )

100 Tuck Hall
Hanover, NH 03755
United States
603-646-0392 (Phone)
603-646-1308 (Fax)