CTC 475 Review Taxes Taxes Types of taxes Types of taxes Income tax is graduated Income tax is graduated ATCF ATCF Calculate Depreciation Calculate Depreciation BTCF-Depreciation=TI BTCF-Depreciation=TI Tax=TI*tax rate Tax=TI*tax rate ATCF=BTCF-Tax ATCF=BTCF-Tax

CTC 475 Effect of interest on ATCF

Objective Know how to develop an ATCF taking into account both depreciation and interest on borrowed money Know how to develop an ATCF taking into account both depreciation and interest on borrowed money

Tax Concepts Depreciation is not a cash flow but is needed to determine taxes Depreciation is not a cash flow but is needed to determine taxes Interest on borrowed money is a cash flow and is also needed to determine taxes Interest on borrowed money is a cash flow and is also needed to determine taxes

Interest Can finance a project with equity (owner’s funds) or debt (borrowed funds) Can finance a project with equity (owner’s funds) or debt (borrowed funds) If money is borrowed principle and interest must be repaid If money is borrowed principle and interest must be repaid Interest is a cash flow and affects taxable income Interest is a cash flow and affects taxable income Principle is a cash flow but does not affect taxable income Principle is a cash flow but does not affect taxable income

Methods for borrowing money 1. Periodic payment of interest with all principle being repaid at end of repayment period. 2. Uniform payment of principle. 3. Uniform payment of (principle and interest). 4. Pay nothing until end of repayment period.

Example Problem-Method 1-4 Borrowed amount = $40K Borrowed amount = $40K $40K borrowed at 18% per year over 5 years; equal payments $40K borrowed at 18% per year over 5 years; equal payments 18% per year compounded annually 18% per year compounded annually Repayment period-5 years Repayment period-5 years

Method 1-Pay Interest Periodically EOY Interest Payment Principle Payment Total Payment %*40K= $7,200 0$7,200 2$7,2000$7,200 3$7,2000$7,200 4$7,2000$7,200 5$7,200$40,000$47,200

Method 2-Pay Principal Periodically EOY Interest Payment Principle Payment Remaining Principle Total Payment 0$40,000 1$7,200$8,000$32,000$15,200 2$5,760$8,000$24,000$13,760 3$4,320$8,000$16,000$12,320 4$2,880$8,000$8,000$10,880 5$1,440$8,000$0$9,440

Method 3-Uniform Payment EOY Interest Payment Principle Payment Remaining Principle Total Payment 0$40,000 1$7,200$5,591$34,409$12,791 2$6,194$6,598$27,811$12,791 3$5,006$7,785$20,026$12,791 4$3,605$9,186$10,840$12,791 5$1,951$10,840$0$12,791

Method 4-Pay All at End EOY Interest Payment Principle Payment Total Payment 0 1$0$0$7,200 2$0$0$7,200 3$0$0$7,200 4$0$0$7,200 5$51,510$40,000 40K(F/P18,5)= $91,510

Example Problem-ATCF Cost Basis = $82K Cost Basis = $82K $42K equity $42K equity $40K borrowed at 18% per year over 5 years; equal payments $40K borrowed at 18% per year over 5 years; equal payments Salvage Value = $5K Salvage Value = $5K Estimated useful life = 7 years Estimated useful life = 7 years MARR=15% MARR=15% Reduction in expenses =$23.5/yr Reduction in expenses =$23.5/yr Depreciate using MACRS-GDS Depreciate using MACRS-GDS 5-year property 5-year property Determine PW of BTCF & ATCF Determine PW of BTCF & ATCF

PW of BTCF PW=$17,649 (BTCF) PW=$17,649 (BTCF) PW=$3,010 (BTCF-depreciation only and all equity) PW=$3,010 (BTCF-depreciation only and all equity)

ATCF-Calculate Depreciation EOYCalculation Depreciation (MACRS) 120%*$82K=$16, %*$82K=$26, %*$82K=$15, %*$82K=$9, %*$82K=$9, %*$82K=$4,723

Calculate Payment Size Assume method 3 (uniform payment) Assume method 3 (uniform payment) Payment Size, A=$40,000(A/P 18,5 ) Payment Size, A=$40,000(A/P 18,5 ) Payment size = $12,792 Payment size = $12,792

Calculate Interest & Principle EOYInterestPrinciple Remaining Principle 0$40,000 1 $7,200 (40K*.18) $5,592 (12,792-7,200) $34,408 2 $6,193 ($34,408*.18) $6,599 (12, ) $27,809 3$5,006$7,786$20,023 4$3,604$9,188$10,835 5$1,950$10,842~$0

ABCDEFGH (B-D-E)(F*.34)(B-C-D-G) EOYBTCFPRINCINT DEPRE C TITAXESATCF 0-42K-42, K5,5917,20016, , K6,5986,19426,240-8,934-3,03813, K7,7855,00615,7442, , K9,1863,6059,44610,4493,5537, K10,8391,9519,44612,1034,1156, K4,72318,7776,38417, K23,5007,99015,510 75K5,0001,7003,300

PW of ATCF Must take each year back to zero (no series because each year has a different number) Must take each year back to zero (no series because each year has a different number) PW=-$42K+$10,743(P/F 15,1 )+$13,746(P/F 15,2 ) PW=-$42K+$10,743(P/F 15,1 )+$13,746(P/F 15,2 ) +$9,774(P/F 15,3 )+$7,156(P/F 15,4 ) +$5,695(P/F 15,5 )+$17,116(P/F 15,6 ) +$15,510(P/F 15,7 )+$3,300(P/F 15,7 ) PW of ATCF=$6,010 (cost effective and higher than if company had funded 100% with equity) PW of ATCF=$6,010 (cost effective and higher than if company had funded 100% with equity)

ATCF’s are impacted by: Depreciation methods Depreciation methods Recovery period Recovery period Planning horizon Planning horizon Different tax rates Different tax rates Interest rates on borrowed money Interest rates on borrowed money

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