296 Planning and Forecasting
$1.5 million at the end of 10 years. By then, however, the book value of the
brewery will be zero. Thus, the beer company will realize a windfall profit of
$1.5 million. The government will want its share of that windfall profit. Multi-
plying the windfall profit by the tax rate determines the windfall tax. In this
particular case, with a windfall profit of $1.5 million and a tax rate of 40%, the
windfall tax would equal $600 thousand (=$1.5 million× 40%).
Taxable Income and Income Tax
Exhibit 10.2 shows how taxable income and income tax are computed for the
brewery example. Income tax equals EBT times the company’s income tax rate.
In each of years 1 through 10, EBT is $2.7 million, so income tax is $1,080,000
(=$2.7 million× 40%).
Interest Expense
Notice that the calculation of taxable income and income tax in Exhibit 10.2
does not deduct any interest expense. This is not an oversight. Even if the com-
pany intends to finance the new project by selling bonds or borrowing from a
bank, we should not deduct any anticipated interest expense from our taxable
income, and we should not subtract interest payments in the cash f low compu-
tation. We will take the tax shield of debt financing into account later when we
compute the company’s cost of capital. The reason for omitting interest ex-
pense at this stage cuts to the core of the purpose of capital budgeting. We are
trying to forecast how much cash is required from investors to start this project
and then how much cash this project will generate for the investors once the
project is up and running. Interest expense is a distribution of cash to one class
of investors—the debt holders. If we want the bottom line of our cash-f low
computation to ref lect how much cash will be available to all investors, we
must not subtract out cash f low going to one class of investors before we get to
that bottom line.
EXHIBIT 10.2 Income tax forecasts for brewery
project (thousands).Years 1–10
Sales $ 7,000
Cost of goods sold (2,000)
Selling, administrative, and general expenses (1,000)
Advertising (500)
Depreciation (800)
Earnings before taxes $ 2,700
Income tax (40%) $(1,080)