Chapter 90416

Chapter 9

Income Taxes

NCF = cash inflows – cash outflows Cash Flow Before Taxes --- CFBT Cash Flow After Taxes --- CFAT

CFAT = CFBT – Taxes

= CFBT – TI *Te

For an economic analysis: Use effective tax rate Te instead of graduated rates Te includes approximated federal, state & local tax rates

CFBT and CFAT Analysis

CFBT = GI – E – P + S• Gross income GI (positive sign)• Salvage value S (positive sign)• Investment P (negative sign)• All business expenses E (negative sign)

CFAT = CFBT – TI*Te

= GI – E – P + S – (GI – E – D)(Te)• Depreciation in TI term; not in CFAT directly

(Remember: depreciation is not an actual cash flow, but it has a “positive” effect!)

CFBT and CFAT Analysis

In an economic analysis In some years, TI may be negative (TI = GI-E-D < 0), if

depreciation exceeds the term GI-E. Then, TI*Te is a tax savings for the year.

Tax savings are offset by taxes imposed elsewhere in the corporation where TI > 0

Once CFAT or CFBT series is estimated Use PW, AW, FW or ROR method to evaluate one project or

multiple alternatives

CFBT and CFAT Analysis

Example 4: Perform before-tax analyses using ROR method.

Is the following Project justified?

Cost: P = $300,000 n = 4 years S = 0 MARR = 15%

Income: GI = $200,000 and E = $80,000/year for 4 years

CFBT and CFAT Analysis

PW = -300,000 + 120,000(P/A,i%,4)=0i* = 21.86% > 15%, so project is justified.

Example 5: Perform after-tax ROR analyses at after-tax

MARR = 9.75%

P = $300,000 S = 0 n = 3 years Te = 0.35

Depreciation method: 3-year MACRS

GI = $200,000 and E = $80,000/year for 4 years

CFBT and CFAT Analysis

GI - E - taxes = 120,000 - taxes

PW = -300,000 + 112,997(P/F,i%,1) +···+ 85,781(P/F,i%,4)=0

i* = 15.54% > MARR = 9.75%

Project is still justified.

CFBT and CFAT Analysis

To estimate after-tax ROR, without performing details of after-

tax analysis, an approximate answer is obtained by using

After-tax ROR = Before-tax ROR(1 – Te)

Similar logic holds for MARR when PW or AW analysis is

performed

After-tax MARR = Before-tax MARR(1 – Te)

In Example 4, before-tax MARR = 15% and Te = 35%, then After-tax MARR = 15%(1- 0.35) = 9.75%

After-tax ROR = 21.86%(1- 0.35) = 14.21%So in Example 5, the project is justified

CFBT and CFAT Analysis

CFAT Evaluation of Multiple Alternatives PW method: Use LCM of lives for different life

alternatives

AW method: Preferred method, since LCM or

incremental analysis is not necessary

ROR method: Perform incremental analysis of

CFAT series

CFBT and CFAT Analysis

Depreciation Effect on Taxes

Some aspects of depreciation and tax law alter income tax amounts and patterns:

• Depreciation method• Recovery period • Depreciation recapture (DR)• Capital gain• Capital loss

Depreciation recapture – Occurs at time of sale when asset is sold for more than book value

DR = selling price – book value

Depreciation Recapture

• In the year an asset is sold

• DR = SP – BV• DR occurs when asset is disposed of at end of its life

and MACRS was applied MACRS always depreciates to zero (S = 0) in

year n +1

• DR is taxed as ordinary TI at effective rate of Te

Capital Gains and Losses

Capital Gain (CG)

If P is first cost or initial depreciation basis

CG = selling price – first cost

= SP – PDifficult to predict; usuallyneglected in economic study, except … when asset appreciates,

such as building or land

Taxed as ordinary TI at effective rate Te

Capital Loss (CL)CL occurs when asset is sold for

less than book value

CL = book value – selling price

= BV - SP

Difficult to predict; usually neglected in economic study,except …

in an after-tax replacement study, if defender is traded at ‘sacrifice’ valueFor taxes, CL can only offset

CG of other activities

Tax Treatment Summary

Updated taxable income relation is nowTI = GI – E – D + DR + CG - CL

Effect on Tax - Example

•GI = $100,000 Te = 35% 3-year contract

After 3 years, expected selling prices are:

SP1 = $130,000 SP2 = $225,000

Which one should be purchased if we want to use a criterion of minimizing total taxes incurred at year 3?

Updated taxable income relation is nowTI = GI – E – D + DR + CG - CL

Example 6:

ISEN302-Chapter 13

Effect on Tax - Example

Year Analyzer 1 Analyzer2

1 150*0.2

=30

225*0.2

= 45

2 150*0.32

=48

225*0.32

=72

3 150*0.192

=28.8

225*0.192

=43.2

4 150*0.1152

=17.28

225*0.1152

= 25.92

5 150*0.1152

=17.28

225*0.1152

= 25.92

6 150*0.0576

=8.64

225*0.0576

=12.96

Total 150 225

Total depreciation up to year 31:106,8002: 160,200

Effect on Tax - Example

Book value at year 3 is 150,000-106,800 = 43,200

225,000-160,200 = 64,800

After 3 years, expected selling prices are:

SP1 = $130,000 SP2 = $225,000

When sold after 3 years, there will be depreciation recapture since SP > BV

DR1 = 130,000 – 43,200 = $86,800

DR2 = 225,000 – 64,800 = $160,200

Taxed at Te = 35%

128,000 44,800

$66,500

207,000 72,450$94,500

TI = 100,000 – 30,000 – 28,800 + 86,800 = $128,000

TI = 100,000 – 30,000 – 43,200 + 160,200 = $207,000

Analyzer 1 has tax advantage

Effect on Tax - Example

TI = GI – E – D

TI = GI – E – D + DR + CG - CL