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Chapter 11 Corporate Income Taxes

Chapter 11 Corporate Income Taxes. Income tax rates Average vs. Marginal tax rates Gains taxes Income tax rate for economic analysis. Corporate Income Taxes (Year 2000). (dollars in millions). Taxable Income and Income Taxes. Item. Gross Income Expenses

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Chapter 11 Corporate Income Taxes

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  1. Chapter 11Corporate Income Taxes • Income tax rates • Average vs. Marginal tax rates • Gains taxes • Income tax rate for economic analysis (c) 2001 Contemporary Engineering Economics

  2. Corporate Income Taxes (Year 2000) (dollars in millions) (c) 2001 Contemporary Engineering Economics

  3. Taxable Income and Income Taxes Item Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income (c) 2001 Contemporary Engineering Economics

  4. Example 11.1- Net Income Calculation (c) 2001 Contemporary Engineering Economics

  5. Capital Expenditure versus Depreciation Expenses 1 2 3 4 5 6 7 8 0 Capital expenditure (actual cash flow) $28,000 0 1 2 3 4 7 6 7 8 $1,250 $2,500 $2,500 $3,500 $2,500 $4,000 $4,900 $6,850 Allowed depreciation expenses (not cash flow) (c) 2001 Contemporary Engineering Economics

  6. Cash Flow vs. Net Income Net income: Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow: Given the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, it is desirable why cash flows are relevant data to use in project evaluation. (c) 2001 Contemporary Engineering Economics

  7. Why Do We Use Cash Flow in Project Evaluation? Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period. (c) 2001 Contemporary Engineering Economics

  8. Example 11.2 – Cash Flow versus Net Income (c) 2001 Contemporary Engineering Economics

  9. Net income versus net cash flow Net cash flows = Net income + non-cash expense (depreciation) $50,000 Net income $12,000 Net cash flow $40,000 $4,000 Depreciation Income taxes $8,000 $30,000 Gross revenue $6,000 Operating expenses $20,000 $10,000 $20,000 Cost of goods sold $0 (c) 2001 Contemporary Engineering Economics

  10. U.S. Corporate Tax Rate (2001) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $0 + 0.15(D) $7,500 + 0.25 (D) $13,750 + 0.34(D) $22,250 + 0.39 (D) $113,900 + 0.34 (D) $3,400,000 + 0.35 (D) $5,150,000 + 0.38 (D) $6,416,666 + 0.35 (D) (D) denotes the taxable income in excess of the lower bound of each tax bracket (c) 2001 Contemporary Engineering Economics

  11. Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000 (c) 2001 Contemporary Engineering Economics

  12. Example 11.3 - Corporate Income Taxes Facts: Capital expenditure $100,000 (allowed depreciation) $58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold $840,000 Depreciation $58,000 Leasing warehouse $20,000 Question: Taxable income? (c) 2001 Contemporary Engineering Economics

  13. Taxable income: • Gross income $1,250,000 • - Expenses: • (cost of goods sold) $840,000 • (depreciation) $58,000 • (leasing expense) $20,000 • Taxable income $332,000 • Income taxes: • First $50,000 @ 15% $7,500 • $25,000 @ 25% $6,250 • $25,000 @ 34% $8,500 • $232,000 @ 39% $90,480 • Total taxes $112,730 (c) 2001 Contemporary Engineering Economics

  14. Average tax rate: • Total taxes = $112,730 • Taxable income = $332,000 • Marginal tax rate: • Tax rate that is applied to the last dollar earned • 39% (c) 2001 Contemporary Engineering Economics

  15. Disposal of Depreciable Asset • If a MACRS asset is disposed of during the recovery period, • Personal property: the half-year convention is applied to depreciation amount for the year of disposal. • Real property: the mid-month convention is applied to the month of disposal. (c) 2001 Contemporary Engineering Economics

  16. Disposal of a MACRS Property and Its Effect on Depreciation Allowances (c) 2001 Contemporary Engineering Economics

  17. Depreciation recapture Depreciation recapture is taxed as ordinary income. Gains = Salvage value – book value = (Salvage value - cost basis) Capital gains + (Cost basis – book value) Ordinary gains (c) 2001 Contemporary Engineering Economics

  18. Capital Gains and Ordinary Gains Capital gains Total gains Ordinary gains or depreciation recapture Book value Salvage value Cost basis (c) 2001 Contemporary Engineering Economics

  19. Full Full Half 8.92 8.92 14.29 24.49 17.49 12.49 8.92 Gains or Losses on Depreciable Asset Example 11.5: A Drill press: $230,000 Project year: 3 years MACRS: 7-year property class Salvage value: $150,000 at the end of Year 3 Total Dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308 Book Value = 230,000 -109,308 = $120,693 Gains = Salvage Value - Book Value = $150,000 - $120,693 = $29,308 Gains Tax (34%) = 0.34 ($29,308) = $9,965 Net Proceeds from sale = $150,000 - $9,965 = $140,035 (c) 2001 Contemporary Engineering Economics

  20. Calculation of Gains or Losses on MACRS Property (c) 2001 Contemporary Engineering Economics

  21. How to Determine Income Tax Rate to be Used in Economic Analysis? (c) 2001 Contemporary Engineering Economics

  22. Incremental Income Tax Rate Average tax rate 17.86% 20.94%31.75% (c) 2001 Contemporary Engineering Economics

  23. 0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75% $20,000 incremental taxable income due to undertaking project Regular income from operation $5,000 at 25% $15,000 at 34% Marginal tax rate 15% 25% 34% $20,000 $40,000 $60,000 $80,000 $100,000 (c) 2001 Contemporary Engineering Economics $0

  24. Summary • Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project. • Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole. (c) 2001 Contemporary Engineering Economics

  25. For corporations, the U.S. tax system has the following characteristics: • 1. Tax rates are progressive: The more you • earn, the more you pay. • 2. Tax rates increase in stair-step fashion: • four brackets for corporations and two • additional surtax brackets, giving a total • of six brackets. • 3. Allowable exemptions and deductions • may reduce the overall tax assessment. (c) 2001 Contemporary Engineering Economics

  26. Marginal tax rate is the rate applied to the last dollar of income earned; • Average (effective) tax rate is the ratio of income tax paid to net income; and • Incremental tax rate is the average rate applied to the incremental income generated by a new investment project. • Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%. • Capital losses are deducted from capital gains; net remaining losses may be carried backward and forward for consideration in years other than the current tax year. (c) 2001 Contemporary Engineering Economics

  27. An investment tax credit is a direct reduction of income taxes payable, arising from the acquisition of depreciable assets. Government uses the investment tax credit to stimulate investments in specific assets or in specific industries. (c) 2001 Contemporary Engineering Economics

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