Certified Valuation Analyst (CVA) Practice Exam

When calculating after-tax economic earnings, what is the effect of tax rates?

1. They decrease the total earnings

2. They have no effect

3. They will always increase the after-tax earnings

4. They only apply to future projections

The correct answer is: They decrease the total earnings

When calculating after-tax economic earnings, tax rates play a crucial role as they directly reduce the total earnings generated by a business or investment due to the obligation to pay taxes on profits. Therefore, as tax rates increase, the amount of earnings retained after taxes decreases, leading to lower overall economic earnings reported. The concept revolves around the idea that businesses must consider not just their gross income but also how much of that income will ultimately be taken by taxes. For instance, if a company has a profit margin of $100, and the tax rate is 30%, the actual earnings available after tax would be $70 ($100 - $30 in taxes). Consequently, the higher the tax rate, the lower the after-tax economic earnings; thus, tax rates undeniably decrease total earnings once tax liabilities are taken into account. Other options do not accurately capture the relationship between tax rates and economic earnings. For example, stating that tax rates have no effect ignores the fundamental impact of taxation on net profits. Similarly, claiming they will always increase after-tax earnings is incorrect, as higher tax rates obviously decrease the retained earnings. The assertion that tax rates only apply to future projections does not hold, as tax rates affect current earnings as well.