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An Investigation of the Rule-of-Thumb Method of Estimating After-Tax Rates of Return

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Abstract:

The effect of income taxes may significantly alter an investment's expected profitability relative to competing alternatives. With one exception, both post-tax cash flows and a post-tax discount rate must be used if the effects of taxation are to be correctly incorporated into an investment analysis. The adjustment of the pre-tax discount rate to a post-tax rate often is accomplished by using an estimate derived by rule-of-thumb. This estimate (effectively reducing the pre-tax rate by the product of itself and 1 minus the marginal income tax rate) is accurate only when the alternative used to determine the opportunity cost of capital involves a nondepreciating asset, returning equal annual payments, whose salvage value is exactly 100% of first cost, or where the alternative investment's life is equal to 1 year. For alternatives with depreciable, depletable, or tax-deferred assets, the rule-of-thumb estimate is not accurate. Its accuracy depends on the alternative's real rate of return, the investor's marginal income tax rate, the level of inflation, and the investment period. In general, the rule-of-thumb method's accuracy decreases as the real rate of return decreases and as the income tax rate, inflation, and investment period increase. In addition, its accuracy is further decreased as depreciation or depletion is accelerated, or if an investment tax credit is included as part of the expected income stream. For. Sci. 36(4):878-893.

Keywords: Income taxation; depletion; depreciation; discount rate; forest taxation

Document Type: Journal Article

Affiliations: Associate Professor, Department of Forestry, Iowa State University, 251 Bessey Hall, Ames, IA 50011

Publication date: December 1, 1990

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