Taxing Example

1. Taxing Example • Former English soccer star David Bledham has announced that he will partner with the Martin E. Drey Casting Co. to produce plastic cell phone covers with photos of Mr. Bledham’s 10 most famous head-butts screen printed on them. • To begin production, the business major running the casting company discovers that he needs to purchase an injection molding machine at a cost of $136 000. The machine will require a water line and electrical service to be installed on the plant floor, costing $220. Two journeymen (a plumber and an electrician) will need to work 14.5 hours each to install the lines and set-up the machine, and both charge $48.28 an hour. As a nice inducement to get the job done fast, the Bledham-Drey project will provide a free lunch to these two laborers, at a total cost of $34. Shipping the equipment costs $2 700. • What is the cost basis for this equipment?

2. Cost Basis: costs required to put an asset into productive service • 1st Cost $136 000 • Shipping $ 2 700 • Installation Labor $ 1 400 = 2($48.28)(14.5) • Installation Mat’ls $ 220 • Total: $140 320 • Note: there is no free lunch – not directly required to put into production; and more appropriately taxed on the journeymen’s tax returns. • The cost basis is required to compute depreciation!

3. Taxing Example, cont. • The Bledham-Drey Co. will pay an operator $22.50 / hr and provide benefits of $15 / hr for insurance, etc. The operator will work 40 hrs/wk, for 50 wks/yr, and her salary will inflate at 4% annually. • What are the project operating costs for Years 1 & 2? • The plastic for each cover will require 27g at a cost of $0.07 per gram. Plastic costs will inflate at 8%/yr, and the business major expects to sell 230 000 covers each year. • What are the cost of goods sold for Years 1 & 2? • This equipment is depreciated on the 7 year MACRS schedule. • What are the depreciation deductions for Years 1 & 2? • If the equipment is sold at the start of Year 3 (Jan. 1), what is it’s book value?

4. Starting to piece together the Net Profit Statement: • 1st Year Operation Cost = ($22.50 + $15.00)(40)(50)= $75 000 • 2nd Year Operation Cost = $75 000(1+f )n = $75 000(1+.04)1 • = $78 000 • 1st YearCost of Goods Sold = (27)($0.07)(230 000)= $434 700 • 2nd Year Cost of Goods Sold = $434 700(F/P,8%,1)= $469 476 • 1st Year Depreciation = (14.3%)($140 320) = $20 066 • 2nd Year Depreciation = (24.5%)($140 320) = $34 378 • Book Value = ($140 320) [1 – (.143 + .245 + .175 / 2)] = $73 598

5. Taxing Example • Bledham-Drey takes out an $800 000 loan for 5 years at 12% interest. The interest-only portion of their payments is $96 000 for the first year, and $80 890 in the second. • Find the loan payments if they are made annually. • If the company has revenues of $700 000 in the first year, and $742 000 in the second year, find the ATCF for both years, assuming a marginal tax rate of 39%. • If the company sells the equipment at the start of Year 3 for $88 000 and immediately pays off the $533 050 remainder of the loan, what does the ATCF diagram look like for the whole project? • If the required MARR is 18%, is project worth doing?

6. Computing the Net Profit Statement Components: • Loan payments = $800 000(A/P,12%,5) = $221 920 each year • 1st Year Taxable Income = Revenue – Expenses • = $700 000 – ($75 000 + $434 700 + $96 000 + $20 066) • = $74 234 • 2nd Year Taxable Income = Revenue – Expenses • = $742 000 – ($78 000 + $469 476 + $80 890 + $34 378) • = $79 256 • 1st YearTaxes = (39%)($74 234)= $28 951 • 2nd Year Taxes = (39%)($79 256)= $30 910

7. Completing the Net Profit Statement: • Year 1 Year 2…. • Revenues $700 000 $742 000 • Expenses • Operations $ 75 000 $ 78 000 • Cost of Goods Sold $434 700 $469 476 • Interest Paid $ 96 000 $ 80 890 • Depreciation $ 20 066 $ 34 378 • Taxable Income $ 74 234 $ 79 256 • Taxes (39% Marginal Rate) $ 28 951 $ 30 910 • Net Profit (Loss) $ 45 283 $ 48 346 • Note: This is not actual cash flow …. • See the After Tax Cash Flow, next!

8. Computing the After Tax Cash Flow (ATCF): • 1st Year After Tax Cash Flow = Revenue – Real Expenses • = Revenue – Operation – COGS – Loan Pmts – Taxes • =$700 000 – ($75 000 + $434 700 + $221 920 + $28 931) • = – $60 571 • 2nd Year ATCF = Revenue – Real Expenses • = Revenue – Operation – COGS – Loan Pmts – Taxes • =$742 000 – ($78 000 + $469 476 + $221 920 + $30 910) • = – $58 306 • 3rd YearDepreciation tax impact = –(Dn)(I)(Marginal Tax Rate) • = (0.5)(17.5%)($140 320) (39%) = – $4 788 • Sale of equipment: tax cash flow (Jan 1, Year 3) • (Sale Price – Book Value) (Marginal Tax Rate) • = ($88 000– $73 598) (.39) = $5 617 • 3rd Year ATCFSale= Sale Price –Tax Cash Flow –Dep. Tax Impact • = $88 000– $ 5 617 – (–$ 4 788) = $87 171

9. $ 659 680 yrs 0 1 2 3 $ 60 571 $ 58 306 $ 445 879 Completing the ATCF Diagram: • Computing Year 3 Net Cash Flow: ATCFsale – Loan Payoff Cost = $ 87 171 –$ 533 050 = – $ 445 879 • Year 0 Net Cash Flow = Loan – Cost Basis • = $ 800 000 – $ 140 320 = $ 659 680 • Project After Tax Cash Flow Diagram: • Note: This IS actual cash flow!

10. Computing the Net Present Worth of the ATCF: • NPW = $ 659 680 • – $ 60 571 (P/F,18%,1) • – $ 58 306 (P/F,18%,2) • – $ 445 879 (P/F,18%,3)= $259 438 • Since this is greater than $0, we are making more than 18% – so must be worth doing! • But ... what would have been smarter?