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CHAPTER 17

M c. Graw. Hill. ENGINEERING ECONOMY Fifth Edition. Blank and Tarquin. CHAPTER 17. AFTER-TAX ECONOMIC ANALYSIS. M c. Graw. Hill. ENGINEERING ECONOMY Fifth Edition. Blank and Tarquin. CHAPTER 17. Learning Objectives. 17. Learning Objectives. Terminology and Rates

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CHAPTER 17

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  1. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 AFTER-TAX ECONOMIC ANALYSIS Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  2. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 Learning Objectives Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  3. 17. Learning Objectives • Terminology and Rates • Before- and After-Tax Analysis • Taxes and Depreciation • Depreciation Recapture and Capital Gains • After-Tax Analysis • Spreadsheets • After-tax Replacement • Value-added Analysis Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  4. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 17.1 INCOME TAX TERMINOLOGY AND RELATIONS FOR CORPORATIONS AND INDIVIDUALS Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  5. 17.1 Important Terms: Gross Income • Gross Income • Total income for the tax year from all revenue-producing functions of the enterprise. • Sales revenues, • Fees, • Rent, • Royalties, • Sale of assets Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  6. 17.1 Income Tax • The total amount of money transferred from the enterprise to the various taxing agencies for a given tax year. • Federal Corporate Taxes are normally paid at the end of every quarter, and a final adjusting payment is submitted with the tax return at the end of the fiscal year. • This tax is based upon the income-producing power of the firm. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  7. 17.1 Operating Expenses (E) • All legally recognized costs associated with doing business for the tax year. • Real Cash Flows, • Tax deductible for corporations, • Wages and salaries, • Utilities, • Other taxes, • Material expenses, • Etc. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  8. 17.1 Taxable Income (TI) • Calculated amount of money for a specified time period from which the tax liability is determined. • Calculated as: • TI = Gross Income – expenses – depreciation • TI = GI – E – D [17.1] Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  9. 17.1 Tax Rate T • A percentage or decimal equivalent of TI. • For Federal corporate income tax T is represented by a series of tax rates. • The applicable tax rate depends upon the total amount of TI. • Taxes owed equals: • Taxes = (taxable income) x (applicable rate) = (TI)(T). [17.2] Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  10. 17.1 Net Profit After Tax (NPAT) • Amount of money remaining each year when income taxes are subtracted from taxable income. • NPAT = TI – {(TI)(T)}, = (TI)(1-T). [17.3] Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  11. 17.1 NPAT • Net profits (if positive) represent funds that are the claim of the owners of the firm – NOT the firm! • NPAT can be: • “Saved” by the firm, • Reinvested within the firm, • Paid out as dividends to the stockholders, • Some combination of paying dividends and reinvesting. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  12. 17.1 Federal Corporate Tax Rates • Corporate Tax Rates: • No one single rate; • Series of “graduated” rates; • TI is partitioned into up to 8 brackets of taxable income; • A tax rate is then applied to each bracket of taxable income and then summed across all applicable brackets. • See Table 17-1 for the 8 bracket rates. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  13. 17.1 The Eight Federal Tax Brackets (2002) Taxable Income Bracket Min Bracket Max Bracket $0 $50,000 1 $50,000 $75,000 2 $75,000 $100,000 3 $100,000 $335,000 4 $335,000 $10,000,000 5 $10,000,000 $15,000,000 6 $15,000,000 $18,333,333 7 $18,333,333 Sky's the limit! 8 Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  14. 17.1 Bracket Tax Rates Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  15. 17.1 Example: • Assume TI = $200,000. • Determine the Federal tax liability. • 1st $50,000 (0.15) = $7,500($150,000 left) • Next $25,000 (0.25) = $6,250($125,000 left) • Next $25,000 (0.34) = $8,500($100,000 left) • Now we are in the 4th bracket • Tax all monies between $100,000 to $335,000 at 34% • Last $100,000 (0.34) = $34,000. • Done! Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  16. 17.1 Total Tax on TI = $200,000 • Add the bracket tax amounts: • $7,500 • $6,250 • $8,500 • $34,000 • $56,250 • Tax as a % of TI: • $56,250/$200,000 = 28.13% Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  17. 17.1 Observations • Each bracket rate is termed a “marginal” rate. • Note the bracket rates are: • 15% • 25% • 34% • 39% • 34% • 35% • 38% • 35% Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  18. 17.1 Marginal Tax Rates • The first $50,000 of TI is taxed at the bracket rate of 15%. • Any additional TI over $50,000 flows into the next bracket. • The next $25,000 or part thereof, is taxed at the marginal bracket rate of 25%. • Each additional $ that moves a firm into a higher bracket is taxed at the higher bracket’s tax rate. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  19. 17.1 Tax Bracket Description • A “tax bracket” system is termed a “graduated tax system.” • Additional amounts of taxable income are taxed at the associated bracket tax rate. • The max bracket rate is 39% and the minimum bracket rate is 15%. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  20. 17.1 Observations • Firms with lower TI pay less taxes that firms with much higher TI. • Arguments now for a “flat” tax rate. • Debate this point in class! • For engineering economy studies: • The analyst will not know the exact TI for the firm, so… • Assume a flat rate, which is normally 34% for federal tax analysis (approximation). Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  21. 17.1 State and Federal • Most states have a state and local corporate tax structure. • Firms have to pay: • Federal corporate taxes, and possibly • State corporate taxes, and even • County or city income taxes. • If this is the case, apply a combined tax rate… Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  22. 17.1 Combined Tax Rate • Assume a known state tax rate, then: • Compute: • Effective Tax rate – Te as: • Te = state rate + (1 – state rate) (Federal Rate) • State income taxes are deductible expenses for federal income tax purposes. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  23. 17.1 Personal vs. Corporate • Individuals report total income; • Gross earned income; • However, individuals may not deduct most of their day-to-day living and working expenses. • Individuals must apply the various standard or itemized deductions permitted by current law. • Corporations deduct actual cash-flow expenses. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  24. 17.1 Personal vs. Corporate • Individuals have to file as either: • Single, • Married, • Head of household. • Corporations have no such filing status other than filing as a corporation. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  25. 17.1 Individual Tax Rates • See Table 17-2 on page 547; • Similar bracket design with 5 brackets; • 15% • 28% • 31% • 36% • 39.6% • The bracket amounts depend upon filing status (Single, Married, Head of Household). See Example 17.2 Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  26. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 17.2 BEFORE-TAX AND AFTER-TAX CASH FLOW Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  27. 17.2 NET CASH FLOW –NCF • NCF represents: • Cash Inflow – Cash Outflows for a given time period. • From economy studies the engineer will estimate the future net cash flows associated with the project over its estimated life. • Now, we define Cash Flow Before Tax (CFBT). Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  28. 17.2 Cash Flows Before Tax (CFBT) • CFBT: • Actual real cash flows associated with an investment BEFORE any income tax considerations are applied. • CFBT does not consider depreciation or depletion amounts. • Next, CFBT will be defined. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  29. 17.2 CFBT Defined • CFBT = • Gross income – expenses – initial investment + salvage value • CFBT= GI – E – P + S [17.7] • Note: • Depreciation and depletion amounts are not part of CFBT as they are not real cash flows per se. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  30. 17.2 Cash Flow After Tax ( CFAT) • CFAT for a given time period is defined as: • CFAT = CFBT – Taxes. • The “Taxes” component must be expanded to include the impacts of depreciation and or depletion. • Depreciation is a noncash flow, but is deductible from GI and serves to moderate (lessen) the TI amount. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  31. 17.2 Expanding the CFAT Amount • Specifically: • CFAT = GI – E – P + S –(GI-E-D)(TE) • Note the (GI-E-D)(Te) term. • (GI – E – D) represent the taxable income component; • Multiplying (GI – E – D) by Te computes the tax on the taxable income part. • Then the tax is subtracted from the CFBT to yield the CFAT amounts. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  32. 17.2 Some Observations • Focus on: (GI – E - D). • For some time periods this term could be negative. • Operating “loss,” which can generate a “negative” tax. • If this is the case, then “so be it.” • Let the sign take care of itself! Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  33. 17.2 CFBT: Format • A tabular approach is suggested. • Numerous formats exist and no one single format or design is “the best.” • See Table 17-3 and Example 17.3 • Suggested tabular format follows. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  34. 17.2 BTCF Format with Example 17.3 Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  35. 17.2 ATCF Format: Example 17.3 First four columns are presented….. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  36. 17.2 ATCF Format: Example 17.3 Last four columns are presented….. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  37. 17.2 ATCF Amounts from Column 7 These amounts represent the after-tax cash flow values for years 0–6. The analyst can calculate PW, FW, AW, IROR, etc. using the methods in the previous chapters. The Goal: Is this investment acceptable? Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  38. 17.2 ATCF Calculations • Best performed with a spreadsheet model as shown. • Depreciation amounts can be calculated in another spreadsheet and copied (values only) into the ATCF worksheet. • User inputs besides the CF values are the discount rate and the tax rate. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  39. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 17.3 EFFECT ON TAXES OF DIFFERENT DEPRECIATION METHODS AND RECOVERY PERIODS Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  40. 17.3 Criteria for Selection • Given two or more depreciation (recovery) plans and: • Constant single value tax rate; • Same recovery period; • CFBT > depreciation amount for the given year; • The methods reduce the basis to the same book value over the same time period. • Compute the PW (i%) of the future tax savings for each plan. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  41. 17.3 Multiple Criteria Can Be Used • Minimize the present worth at some i% over n time periods of the tax; • Maximize the present worth at some i% over n time periods of the taxes saved. • PWTAX is defined by: Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  42. 17.3 Rule: • For depreciation plans over the same recovery period, and targeting the same salvage value: • The total taxes saved are equal for all depreciation models; • The present worth of taxes saved is always less for accelerated depreciation methods. • See Table 17-4! Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  43. 17.3 The Goal! • If the firm is profitable and the TI amount is > 0, then: • Using a depreciation plan that writes off more of the asset in the early years is preferred! • Achieving greater tax savings early on permits the firm to retain more after-tax dollars; • Which can be reinvested at or above the firm’s MARR! • Promote future wealth maximization! Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  44. 17.3 Comparing Depreciation Plans Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  45. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 17 17.4 DEPRECIATION RECAPTURE AND CAPITAL GAINS AND LOSSES FOR CORPORATIONS Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  46. 17.4 CAPITAL GAIN OR GAIN ON SALE • Firms sell or dispose of assets from time to time. • Those assets have been fully depreciated, or are still being depreciated for tax purposes. • Assets that are disposed do have a book value. • Could be + or, • Could be “0”. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  47. 17.4 Capital Loss: CL • A capital loss occurs when an asset is sold for less than its current book value. • Could generate a tax savings since the “loss” could be tax deductible within certain rules. • CL = BVt - SP Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  48. 17.4 Gain on Sale (Capital Gain) • Gain on Sale is defined as: • GS = Selling Price – Current Book Value; • Capital Gain is defined as: • CG = Selling Price – First Cost. • Certain Assets will gain value over time and could be sold for more than what was originally paid for them. • This will generate a tax liability and tax will have to be paid! Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  49. 17.4 Sale of Productive Assets • Confine discussion to the disposal of productive assets. • The term “Depreciation Recapture” applies. (DR). • DR = SP – BVt[ 17.12 ] • Three possible outcomes can happen when a productive asset is disposed at time t. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

  50. 17.4 Disposal – 3 Outcomes • The asset is sold for a price > BVt • SP > BVt generates a tax liability • The asset is sold for a price = BVt • SP = BVt no tax liability generated • The asset is sold for a price < BVt • SP < BVt generates a tax savings • Assume a tax rate – Te applies. Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

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