Chapter 11 - Income Taxes Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR Cal Poly Pomona - SA142 EGR The Big Picture Framework: Accounting & Breakeven Analysis “Time-value of money” concepts - Ch. 3, 4 Analysis methods –Ch. 5 - Present Worth –Ch. 6 - Annual Worth –Ch. 7,7A,8 - Rate of Return (incremental analysis) –Ch. 9 - Benefit Cost Ratio & other methods Refining the analysis –Ch. 10, 11 - Depreciation & Taxes –Ch Replacement Analysis

EGR Cal Poly Pomona - SA143 Income Taxes Taxes have an impact on cash flow and affect the decisions management makes concerning investments. Integrating tax considerations into economic analysis requires a thorough understanding of two issues. –How the taxes are imposed. –How they affect the economic analysis techniques.

EGR Cal Poly Pomona - SA144 A Partner(s) in the Business For simplification 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 in the manner in which they are administered. 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

EGR Cal Poly Pomona - SA145 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 interest (PW, IRR, payback, etc.).

EGR Cal Poly Pomona - SA146 Calculation of Taxable Income Tax laws can be very complex leading to very complex calculations. A tax is just another disbursement for services rendered.

EGR Cal Poly Pomona - SA147 Classification of Business Expenditures Capital expenses. –Expenditures for depreciable assets. Generally those items having a life in excess of one year. –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.

EGR Cal Poly Pomona - SA148 Taxable Income of Business Firms Taxable income = gross income - operating expenses - depreciation

EGR Cal Poly Pomona - SA149 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. US corporate income tax rates are found in internal revenue service form 1120.form 1120

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EGR Cal Poly Pomona - SA1413 Example of How to Use Table Corporate Before Tax Profit: $15,000,000 Federal Tax (from tax rate table): = $3,400, ($15,000,000 - $10,000,000) = $3,400,000 + $1,750,000 = $5, 150,000

EGR Cal Poly Pomona - SA1414 When you sell a capital asset for more than the book value, it is treated as a profit or a gain and taxes are due

EGR Cal Poly Pomona - SA1415 Economic Analysis Taking Income Taxes Into Account Principle 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

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EGR Cal Poly Pomona - SA1420 Figuring Personal Income Taxes Gross Income (wages, tips, interest, dividends) Less: Adjustments (tax deferred investments: 401k, IRA) = adjusted gross income Less: exemptions (2750/dependent, includes you) Less: deductions - choose the most favorable of: Standard deduction: $4300 if single or $7200 if married (1999) [Note: $4700 single or $7850 (2002)], or Itemized deductions (donations, some taxes, interest on your home, major medical expenses and losses) = Taxable income Use tables to determine taxes owed on taxable income.

EGR Cal Poly Pomona - SA1421 Example 1 - Single Student Gross Income: $8000 Adjusted Gross Income: $8000 Deduction for one exemption: - $2750 Standard deduction: - $4300 (1999 tax year) Taxable income = $950 Taxes owed = 0.15 * $950 = $142.50

EGR Cal Poly Pomona - SA1422 Example 2 -Young Single Engineer Salary: $50,000 Tax Deferred Investment into 401k: -$5000 Adjusted Gross Income = $45,000 One exemption: - $2750 Standard deduction: - $4300 (1999 tax year) Taxable Income = $37,950 Taxes: $ ($37,950 - $25750) = $ $3416 = $

EGR Cal Poly Pomona - SA1423 Young Single Engineer Buys a Condo Cost: $220,000 with down payment of $20,000 Loan: $200,000, 30 years, 6% nominal Monthly Payments: $ (fixed!) Approximate first year interest: $12,000 Tax savings from $12,000 itemized deduction: 0.28 * $12,000 = $3360 Property taxes (approx. 2% of value) are also deductable