Reviewing…

1. Reviewing… • We covered the following depreciation methods: • Straight Line • Declining Balance • Sum of Years Digits • Units of Production • MACRS – Modified Accelerated Cost Recovery System

2. Effective Tax Rates Terminology: Federal Tax Rate (FTR) Federal Taxable Income Federal Taxes = Federal Tax Rate x Federal Taxable Income State Tax Rate (STR) State Taxable Income State Taxes = State Tax Rate x State Taxable Income

3. Effective Tax Rates • State taxes are deductible when calculating Federal taxable income. • Effective Tax Rate = • FTR (1 – STR) + STR

4. Marginal Tax Rates • Tax rates for corporations and individuals vary depending on the amount of taxable income. • Different tax rates apply to incremental income.

5. Marginal Tax Rates 2010 Federal Personal (Single) Tax Schedule These marginal tax rates apply to personal income – and business income that is reported via personal income tax returns (proprietorships and partnerships). Corporations have an additional surtax in some income ranges, sometimes resulting in a higher marginal tax rate (see next slide).

6. Marginal Tax Rates 2010 Federal Corporate Tax Schedule

7. Average Tax Rate vs. Marginal Tax Rate Example: $125,000 in taxable income Average Tax Rate: Marginal Tax Rate:

8. Assumptions • Company already has taxable income. • We need to know the marginal tax rate. • Assume project will keep me in the same marginal tax bracket.

9. After Tax Analysis • 1. Determine Taxable Income: • ( + ) Income • ( - ) Expenses • ( - ) Interest Paid • ( - ) Depreciation (Not a real cash flow) • Determine Taxes • Use the marginal tax rate • Determine After Tax Cash Flow • ( + ) Income • ( - ) Expenses • ( - ) Loan Payments • ( - ) Tax cash flow

10. After Tax Analysis Example: Determine year 1 cash flows with marginal tax rate of 39%: Gross Income = $7,000 Cost of Goods Sold = $1,000 Operating Expense = $3,000 Depreciation Charge = $2,000 Loan Payment = $2,802 Interest Expense = $1,200

11. Sale of Asset • End of the year taxable income from sale = Sale Price – Book Value • Tax cash flow from sale of the asset = taxable income from sale x marginal tax rate • After tax cash flow = • sale price – tax cash flow from sale of the asset

12. Early Sale of Asset Half Year Convention: • It is assumed that an asset is put into service half-way through the initial year – so only ½ year of depreciation may be claimed in Year 1. • MACRS table takes care of this, automatically • If selling an asset before the final year of MACRS depreciation, only ½ year of depreciation may be claimed in that year … • Reduce depreciation amount by ½, and… • Increase book value by ½ depreciation amount

13. Sale of Asset Example A machine was purchased on January 1, 1999, for $10,000. It has been depreciated using the MACRS 5 year schedule. It can be sold for $8,000 on December 31, 2001. Determine the After Tax Cash Flow (ATCF) for the sale of the machine. The marginal tax rate is 35%.

14. Sale of Asset Example with a Twist - 1! A machine was purchased on January 1, 1999, for $10,000. It has been depreciated using the MACRS 5 year schedule. It can be sold for $8,000 on January 1, 2002. Determine the After Tax Cash Flow (ATCF) for the sale of the machine. The marginal tax rate is 35%.

15. Sale of Asset Example with a Twist - 2! A machine was purchased on January 1, 1999, for $10,000. It has been depreciated using the MACRS 5 year schedule. It can be sold for $2,000 on December 31, 2001. Determine the After Tax Cash Flow (ATCF) for the sale of the machine. The marginal tax rate is 35%.