Assets may change in value according to changes in their operating environment. For example, tastes may change leading to fewer sales, which in turn reduce asset values. Likewise, tax on an asset may increase, decreasing its cash flow and hence its value. Conversely, a decrease in that particular tax will have the opposite effect. Tax capitalization applies your future tax liabilities to your assets’ present values.
Net Cash Flow
In general, the value of an asset depends on the future cash flow it generates. For example, if you rent out a house or an apartment, you will generate a future income stream composed of your tenants’ rents. Being the owner of an asset also implies costs to you; you typically must pay property taxes to your local government. You also may have to bear the costs of repairs. Therefore, to begin assessing the true value of an asset, you must subtract the costs of holding the asset from the income it generates over time.
When you estimate the value of an asset, it is not enough to calculate the future net income stream. Your future net income stream is equal to your future income minus future costs. In a year, income that you earn today will be worth more if it earns interest. You can use the same rate of interest, known as the discount rate, to discount the year-end amount to get your beginning income. So, to calculate the value of an asset today, you must determine the discount rate to account for the reality that the value of future income is worth less than at present. That rate can be, for example, the interest paid by an alternative investment, such as municipal bonds.
Using the discount rate and the net cash flow, you can determine the value of an asset. When you apply the discount rate to the net future cash flow, you arrive at the current value of that future net cash stream. This value is the present value of the net future cash stream, or the net present value. The term net is used because it accounts for the fact that future costs are subtracted from future income.
Tax capitalization refers to how asset value is changed when the cash flow is changed by an increase or decrease in the tax liability for that asset. One of the costs that must be subtracted from a future income stream is the tax assessed on that asset. If, for example, the tax rate were to decrease, the dollar amount of tax would decrease and, therefore, the future income would increase. This results in a larger present value of the newly increased net cash flow. The difference caused by the lower tax rate would be capitalized, that is, it would be incorporated to the original value calculated for that asset. The reverse would hold true if the tax rate were to increase.