Why multiply it by 1-t
Let's say there is an increase of 10$ in depreciation. Depreciation is an expense; hence, an increase in an expense reduces the net income. In particular, net income is reduced by:
Value of increase in an expense*(1-t), where t is the marginal tax rate
But why does it work like this? I do it automatically but I haven't understood the reason.
This is where my reasoning stops:
10$ increase in depreciation means EBIT decreases of 10$. Then that means Pre tax income decreases of 10$. I don't know how to continue.
(In your explanation assume maybe a 40% tax rate)
Like you pointed out, an increase in expense leads to a decrease in profit. However, less profit also means less taxes. Hence, while the incremental effect on pretax income is ($10), the incremental effect on net income is shielded by the $4 reduction in taxes.
Exactly what Fuzzy says. To understand the guide questions, it good to try and understand what's actually happening on the income statement. It sounds like you don't have a background on the IS (which is fine), but just reading the answers to the guides won't help.
Taxes = Tax rate * EBT (earnings before taxes)
Taxes are subtracted from EBT
So,
EBT-EBT*Tax rate = EBT*(1-Tax rate)
This is how I went about understanding questions like yours. Hope this helps.
You're right mate I'm just starting out.
To put it simply, the more you earn, the more you are taxed. You are taxed 40% of every dollar so if depreciation goes up by $10, you get a bit of a tax shield there, as it decreases earnings before tax
Lets see the scenario below:
EBIT 100
100*(1-40%)=60 net income - assuming no interest
Now lets see what happens when $10 of depreciation is added
EBIT 90 because an extra 10 in depreciation decreases earnings
90*(1-40%)= 54 - assuming no interest
You see you only lose $6 instead of $10 in the bottom line because expenses reduce taxes. You actually will see a lot of private companies try and increase expenses as much as they can in order to reduce taxes i.e. trying to expense repairs and maintenance that should be capitalised instead. Public companies don't do this because it would piss off their equity holders as net income can be given to them instead.
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