Chapter 6, Problem 32PS

Effective tax rates One measure of the effective tax rate is the difference between the IRRs of pretax and after-tax cash flows, divided by the pretax IRR. Consider, for example, an investment I generating a perpetual stream of pretax cash flows C. The pretax IRR is C/I, and the after-tax IRR is C(1 – T_C)/I, where T_C is the statutory tax rate. The effective rate, call it T_E, is

$T_{\text{E}}=\frac{C/I-C\left(1-T_C\right)/I}{C/I}=T_C$

In this case, the effective rate equals the statutory rate.

1. a) Calculate the effective tax rate for the guano project in Section 6-3.
2. b) How does the effective rate depend on the tax depreciation schedule? On the inflation rate?
3. c) Consider a project where all of the up-front investment is treated as an expense for tax purposes. Does this definition of the effective tax rate make sense for such a project?