Engineering Economic Analysis Chapter 12 INCOME TAXES

Income Taxes Taxes have an effect on cash flow and affect the investment decisions managers make. Integrating tax considerations into economic analysis requires a thorough understanding of two issues. How the taxes are imposed. How taxes affect the economic analysis techniques.

Government: A Partner(s) in the Business Type of tax Income tax based on earnings Property tax based on property value Sales tax based on purchase price Use tax based on type of use of an item Collected by Federal State County City For simplicity, the text focuses on either Federal income taxes or bundles the tax into a rate that reflects all taxing entities. This is done as the taxes at the state or local level vary widely.

Calculation of After-tax Figure of Merit General Process Understand the tax laws affecting the project of interest. Estimate the cash flows without considering the effect of taxes. Adjust the cash flow based on the effects of depreciation and income taxes. Determine the after-tax measure of merit (PW, IRR, payback, etc.).

Calculation of Taxable Income Tax laws can be very complex, which can lead to very complex calculations. A tax is just another disbursement for services rendered, from the point of view of the cash flows of the firm We will only focus on business taxes in this course

Classification of Business Expenditures Capital expenses Expenditures for depreciable assets Generally those items having a life in excess of one year You have to figure out the depreciation for these items Expenditures for non-depreciable assets Generally land, as land has no finite life Operating expenses Materials, labor, overhead, rents, leases, equipment having a life of less than one year

Taxable Income of Business Firms Taxable income = Gross income − All expenditures except capital expenditures − Depreciation and depletion charges Example 1: During a 3-year period, a firm had the following cash flows (in millions of dollars): Compute the taxable income for each of the 3 years, using Straight Line Depreciation with no salvage value (values in Millions $) Year 1 Year 2 Year 3 Gross income from sales $200 Purchase of special tooling (3 year life) -60 All other expenditures -140 Cash flows for the year 60

Example 1 Solution First compute the depreciation for each year Then subtract the depreciation and other expenditures from the gross income Notice that the spreadsheet has the expenditures with negative signs so be careful in formulas

Example 1: MACRS The depreciation method used impacts the taxable income Here, yr 1 is the same but the other years differ Straight Line MACRS

Income Tax Rates Rates change as the taxing authority requires more or less income. Income tax rates vary, based on the taxable income of the business. A small, highly profitable business might pay more income tax than a large, unprofitable business. Tax rates may change based on Congressional action

Economic Analysis Taking Income Taxes Into Account Principal elements in the after-tax analysis: Before-tax cash flow Investment Benefits - costs Depreciation Taxable income (BTCF - depreciation) Income taxes (Taxable income x incremental tax rate) After tax cash flow (BTCF - income taxes) IRR Example 1

Example 2 The French Chemical Corporation was formed to produce household bleach. The firm bought land for $220,000, had a $900,000 factory building erected, and installed $650,000 worth of chemical and packaging equipment. The plant was completed and operations begun on April 1. The gross income for the calendar year was $450,000. Supplies and all operating expenses, excluding the capital expenditures, were $100,000. The firm will use modified accelerated cost recovery system (MACRS) depreciation. Compute the Taxable Income and Tax for this Year

Example 2: Solution Depreciation for equipment Depreciation for land Used 7 years based on Ch 11 Depreciation for land None Depreciation for the building, starting in April 1.819% based on table 11.4

Example 2 Solution Setup a section for each type of depreciation Setup a section for using a VLOOKUP for the taxes

Section 2 Solution The Taxable Income ends up being so much more than if the expenses were all taken in Year 1 BUT the Taxable Income in later years will also be reduced by spreading the costs out over more years

Example 3 An analysis of a firm’s sales activities indicates that a number of profitable sales are lost each year because the firm cannot deliver some of its products quickly enough. By investing an additional $20,000 in inventory, it is believed that the firm will realize $1000 more in before-tax profits in the first year. In the second year, before-tax extra profit will be $1,500. Profits for subsequent years are expected to continue to increase on a $500-per-year gradient. The investment in the additional inventory may be recovered at the end of a 4-year analysis period simply by selling and not replenishing the inventory. Compute: (a) The before-tax rate of return. (b) The after-tax rate of return assuming an incremental tax rate of 39%.

ATCF (and Example 3) Plan Create cash flows for each year Compute the Before Tax Cash Flow (BTCF) Compute BTCF ROR Compute depreciation Compute taxes (use 39% based on problem) Compute After Tax Cash Flow (ATCF) Compute ATCF ROR

Example 3 Setup This is a standard format for ATCF analysis The depreciation column will usually take values from some intermediate results We can easily use IRR in a computer supported environment We sell the inventory at the end of year 4 to recover that investment

Example 3 results The BTCF ROR implies that buying the extra inventory will earn 8.5% The ATCF ROR tells us that after taxes, the extra inventory will LOSE 5.1%!!!! ROR can be negative!!!!