After-Tax Economic Analysis

1. After-Tax Economic Analysis Gross Income (GI) – total income realized from all revenue-producing sources, including items such as the sales of assets, royalties, license fees, etc… Income Tax – amount of taxes based on gross income. Corporate taxes are typically paid quarterly, and are actual cash flows. Operating Expenses (E) – all corporate costs incurred in the transaction of business.

2. After-Tax Economic Analysis Taxable Income (TI) – the amount upon which taxes are based. TI = ______________ Where D is depreciation defined in previous lecture. Tax Rate (T) – percentage of TI owed in taxes. This rate is graduated, based on TI. (See table 17-1) Net Profit after taxes (NPAT) – amount remaining each year when income taxes are subtracted from taxable income. NPAT = _____________

3. After-Tax Economic Analysis Graduated tax rate schedule (table 17-1, pg. 571)

4. After-Tax Economic Analysis Average Tax Rate – because the marginal tax rate varies as TI varies, the average tax rate is calculate as: Ave tax rate = total taxes / TI Effective Tax Rate (Te) – the total rate paid by corporations, including federal, state and local taxes. Note state taxes can be deducted from federal taxes. So: Te = state rate + (1-state rate)( federal rate)

5. Example: Problem 17.5 a) Average Tax Rate Taxes on $300,000 = ____________________ Ave tax rate = _______________________ Effective Tax Rate (assume state tax = 7% Te = ______________________________

6. CFBT – vs – CFAT • Cash flow before tax (CFBT) – all cash flows throughout the year without considering taxes. Note, all our PW, FW, AW analysis to this point have been CBFT cash flows. CFBT = GI – E – P + S where P is initial investments and S is salvage. • Cash flow after tax (CFAT) – includes the cash flow impact of taxes. CFAT = CFBT - taxes

7. CFBT – vs – CFAT • Knowing CFAT = CFBT – taxes … • Taxes are calculated taking depreciation (D) into account, however depreciation is not a cash flow, but taxes are. Taxes = TI(Te) TI = GI – E – D CFAT = GI – E – P + S – (GI – E – D)(Te)

8. After-Tax Economic Analysis Example 17.3 from Book

9. Definitions Capital Gains (CG): Occurs when selling price is greater than first cost. Capital gain = selling price – first cost CG = SP – P Depreciation Recovery (DR): Occurs when a depreciable asset is sold for more than the current book value. Depreciation recapture = selling price – book value DR = SP – BVt Capital Loss (CL): Occurs when a depreciable asset is disposed of for less than its current book value. CL = BVt - SP

10. DR CG $0 BV P SP DR $0 BV SP P After-Tax Economic Analysis When selling price exceeds first cost then both a capital gain and a depreciation recovery occur. When selling price exceeds book value but is less than he first cost then a depreciation recovery occurs.

11. After-Tax Economic Analysis CL $0 SP BV P When selling price is below book value a capital loss occurs.

12. After-Tax Economic Analysis Considering capital gains, depreciation recovery and capital losses, TI = gross income – expenses – depreciation + depreciation recapture + capital gains – capital loss TI = GI – E – D + DR + CG - CL

13. After-Tax PW and AW Analysis • Relationship between before-tax MARR and after-tax MARR: • Before-tax MARR = • Te for corporations is often between 30 and 50%. After-tax MARR 1 - Te

14. After-Tax PW and AW Analysis • Approach 1: Find the PW or AW of an alternative using the CFAT and the After-tax MARR. That alternative with the largest PW (AW) is chosen. • Note, PW must use LCM (least common multiple of years.)

15. After-Tax Economic Analysis Using cash flows from Example 17.3, and an after-tax MARR of 7%, the PW of this alternative is: PW = - $550,000 + $110,000(P/F, 7%, 1) + $133,100(P/F, 7%, 2) + $108,460(P/F, 7%, 3) + $ 93,676(P/F, 7%, 4) + $ 93,676(P/F, 7%, 5) + $232,588(P/F, 7%, 6) = ______________