AppleTreesandExperience 103winners neglect how much they are losing to tax payments both
outright an din terms of the time value lost by the payments.
Suppose you buy an investment that pays 15% per year for 30
years an dkeep that investment compoun ding yearly until the en dof
that time without being obligate dto pay taxes on it. Suppose also
that you are taxe don your income from that investment at the en d
of that thirtieth year at a rate of 35%. This means your after-tax
annual rate of return on that investment was about 13.3%. Har dto
beat.
Suppose instea dthat your 15% per year investment for 30 years
pays you that 15% annually an dsubjects you to tax of 35% each year
you get it. Your annual after-tax return suddenly shrinks to about
9.75%. Not a ba dnet return, you say, but that is over 3.5% less than
the tax-deferred position. And now we are talking about huge sums,
with that 3.5% difference compounding over periods such as 30
years.
The same is true at every level of return differentials and remains
quite substantial even at lower rates of return. A 10% pretax return
with taxes due only at the end of 30 years gives you an after-tax
return of about 8.3%, compare dwith about a 6.5% after-tax return
if you ha dpai dtaxes on that income each year. Again, that kin dof
2% difference compounded over a few decades works out to be lots
of dollars.^3
Inflation
Our parable’s business school dropout did not know that the value
of money across time is nonlinear. Inflation often differs from re-
turns, an dreturns differ from each other. Annual inflation of 4%
means that a basket of goods that can be bought for $100 on January
1 costs $104 on December 31. But if during that year you put $100
in a savings account paying 8%, your balance at the en dof that year
would be $108. Left uninvested, that $100 would decline in pur-
chasing power to about $96, whereas the investe damount gives you
a purchasing power of about $104 (the $108 you have less the impact
on its buying power of the 4% inflation).
These macroeconomic factors bear on value. Tax an dinflation
in particular determine how much your gross return will give you in
increase dpurchasing power. Changes in interest rates require revis-
ing any valuations made under different interest rate assumptions.
Operating as a business analyst requires knowledge of these things