1 MER Design of Thermal Fluid Systems Basics of Taxation and Bonds Professor Anderson Winter Term 2005

2 Basics of Taxation For Corporations  Corporations pay taxes on income generated while doing business  When performing an economic analysis one must determine if it is a before or after tax analysis  For tax-exempt organizations it is not necessary  Most analysts do after tax analyses

3 Definitions Gross Income - (GI) Total of all income from revenue producing sources Expenses - (E) All costs incurred while transacting business Taxable Income - (TI) The dollar value remaining upon which taxes are to be paid. TI = Gross Income – Expenses – Depreciation

4 Definitions Continued Capital Gain: Gain incurred when the selling price an asset or real property exceed the purchase price (unadjusted basis) Capital Gain = Selling Price – Unadjusted Basis STG= Short Term Gain < 1 y or 6 months LTG= Long Term Gain > 1 yr or 6 months

5 Definitions Continued Capital Loss: Selling Price is Less than BV Capital Loss = BV- Selling Price Short term (STL), Long Term (LTL) Recaptured Depreciation: RD = Selling Price – BV > 0

6 Basic Tax Formulas and Computations Taxes = (GI – E – D)*T = TI*T T = Tax Rate Corporate Federal Income Tax Rate Schedule

7 Example A company has a GI = $2,750,000 with expenses and depreciation = $1,950,000. Compute the federal tax. TI = $2,750,000-1,950,000 = $800,000 Taxes = *(800, ,000) Taxes = $272,000

8 Cash Flow Terms CFBT: Cash Flow Before Taxes CFAT: Cash Flow After Taxes CFBT=Gross Income - Expenses TI = CFBT – Depreciation Taxes = TI*T CFAT = CFBT - Taxes

9 The Effect of Depreciation on Taxes  The amount of taxes incurred is affected by the depreciation model chosen  Accelerated methods require less taxes in the early years  Assumptions: Constant tax rate Gross Income exceeds Annual Depreciation Capital recovery down to same SV Same number of years  Then Total taxes paid are equal for any depreciation models The PW of taxes, P tax, are less for accelerated depreciation models

10 Example Construct the CF diagram for taxes and calculate the PW of taxes for a $9000, 5 year recovery asset if the effective tax rate is 40%. CFBT is estimated at $10,000 per year and the interest rate is 12% per year, Use the 150% declining balance method of depreciation

11 Solution d = 1.5/n = 1.5/5 = 0.3 B = $9000 D t = dB(1-d) t-1 = 0.3(9000)(0.7) t-1 P taxes = $12,094

12 Bonds Bonds are sold by US Gov’, States and Munici- palities, or Corporations as a way to raise taxes. Bond Terminology V = Face Value b = bond interest rate c = number of payments per year I = amount of interest paid per year I = Vb/c.

13 Bond Example A shirt manufacturing company planning an expansion issued 4%, $1000 bonds for financing their project. The bond will mature in 20 years with interest paid semi-annually. Mr. John Doe purchased a bond for $800. What payments will he receive? V = $1000b = 0.04C = 2 I = 1000*.04/2 = $20 every 6 months

14 Bond Present Worth Calculation When a company offers bonds, investors mush determine how much they are willing to pay. 1.Calculate the interest payments (I) per period 2.Draw CF diagram of bond receipts 3.Determine investors desired rate of return per period 4.Add the PWs of all cash flows

15 Bond Present Worth Example Jennifer Jones wants to make a nominal 8% per year compounded semi-annually. How much should she be willing to pay now for a 6%, $10,000 bond that will mature in 15 years and pays interest semiannually? P = $

16 Calculating the ROR on Bond Investments John Doe paid $800 for a 4% $1000 bond which matures in 20 years and pays interest semi-annually. What nominal and effective interest rate will Mr. Doe receive on his investment for semi- annual compounding.