Question

Explain why the marginal tax rate, rather than the average tax rate, is used when computing the cash flows from a proposed new project.

Answer 1

Marginal tax rate is the tax rate applicable on additional income

Average tax rate = Total Tax/Total Income

Tax rates are generally levied on progressive basis i.e. higher tax rates are applicable on higher income slabs. Hence, marginal tax rate is generally higher than the average tax rate.

When a new project is started, it generates additional income i.e. income over and above the present income and hence, tax is paid on such income at the marginal rate and not at average rate.

Using average rate will distort cash flows and may lead to incorrect decisions.

Hence, marginal tax rate is used when computing cash flows from a proposed new project rather than the average tax rate.