1. 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

2. CTC 475 ATCF/EVA

3. Objective Know how to develop an ATCF and EVA cash flow Know how to develop an ATCF and EVA cash flow Know the relationship between before- and after-tax MARR Know the relationship between before- and after-tax MARR

4. 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

5. 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

6. 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 (principle and interest). 4. Pay nothing until end of repayment period.

7. Example Problem-Method 1-4 Borrowed amount = $40K Borrowed amount = $40K 18% per year compounded annually 18% per year compounded annually Repayment period-5 years Repayment period-5 years

8. Method 1-Pay Interest Periodically EOY Interest Payment Principle Payment Total Payment 0 1 18%*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

9. 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

10. 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

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

12. 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

13. PW of BTCF PW=$17,649 (BTCF) PW=$17,649 (BTCF) PW=$3,010 (ATCF-depreciation only and assuming equity used for original costs) PW=$3,010 (ATCF-depreciation only and assuming equity used for original costs)

14. ATCF-Calculate Depreciation EOYCalculation Depreciation (MACRS) 120%*$82K=$16,400 232%*$82K=$26,240 319.2%*$82K=$15,744 411.52%*$82K=$9,446 511.52%*$82K=$9,446 65.76%*$82K=$4,723

15. 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

16. 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 (12,792-6193) $27,809 3$5,006$7,786$20,023 4$3,604$9,188$10,835 5$1,950$10,842~$0

17. ABCDEFGH (B-D-E)(F*.34)(B-C-D-G) EOYBTCFPRINCINTDEPRECTITAXESATCF 0-42K-42,000 123.5K5,5917,20016,400-100-3410,743 223.5K6,5986,19426,240-8,934-3,03813,746 323.5K7,7855,00615,7442,7509359,774 423.5K9,1863,6059,44610,4493,5537,156 523.5K10,8391,9519,44612,1034,1156,595 623.5K4,72318,7776,38417,116 723.5K23,5007,99015,510 75K5,0001,7003,300

18. 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 more cost effective than if company had funded 100% with equity) PW of ATCF=$6,010 (cost effective and more cost effective than if company had funded 100% with equity)

19. See Book page 329:

20. Don’t include interest in ATCF Double counting because interest rates should be included in the determination of MARR Double counting because interest rates should be included in the determination of MARR MARR>WACC (weighted average cost of capital) MARR>WACC (weighted average cost of capital) Debt Capital (bonds; interest on borrowed money) Debt Capital (bonds; interest on borrowed money) Equity Capital (stocks, money on hand) Equity Capital (stocks, money on hand)

21. Before/After Tax MARR AT MARR=BT MARR*(1-effective income tax rate) AT MARR=BT MARR*(1-effective income tax rate) Given: BT MARR=15% Given: BT MARR=15% Calculate: AT MARR (34% tax rate)=9.9% Calculate: AT MARR (34% tax rate)=9.9% Calculate: AT MARR (40% tax rate)=9.0% Calculate: AT MARR (40% tax rate)=9.0% Calculation exact if no depreciation, tax credits, etc. (otherwise, just an estimate) Calculation exact if no depreciation, tax credits, etc. (otherwise, just an estimate)

22. Economic Value Added-EVA EVA k =NOPAT k -MARR*BV (k-1) EVA k =NOPAT k -MARR*BV (k-1) NOPAT-Net Operating Profit After Taxes NOPAT-Net Operating Profit After Taxes K is the year of interest K is the year of interest MARR is minimum attractive rate of return MARR is minimum attractive rate of return BV is book value BV is book value

23. EVA Annual equivalent worth of EVA is equal to AW of ATCF Annual equivalent worth of EVA is equal to AW of ATCF

24. EVA Example-page 343 Cost Basis = $84K Cost Basis = $84K Salvage Value = $0 Salvage Value = $0 Estimated useful life = 4 years Estimated useful life = 4 years AT MARR=12% AT MARR=12% Annual expenses =$30K/yr Annual expenses =$30K/yr Gross revenues=$70K/yr Gross revenues=$70K/yr Depreciate using Straight Line Depreciate using Straight Line Tax Rate=50% Tax Rate=50% Determine AW of ATCF and EVA Determine AW of ATCF and EVA

25. ATCF EOYBTCFDep.TITaxesATCF 0-$84K -$84K 1$40K$21K$19K$9.5K$30.5K 2$40K$21K$19K$9.5K$30.5K 3$40K$21K$19K$9.5K$30.5K 4$40K$21K$19K$9.5K$30.5K

26. AW of ATCF AW=-$84,000(A/P12,4)+$30,500=$2,844 AW=-$84,000(A/P12,4)+$30,500=$2,844

27. EVA Calculation EOYNOPAT=TI-TAXNOPAT-i*BVEVA 1$19K-$9.5K=$9,500 $9,500- 0.12*($84K)= -$580 2$9,500 $9,500- 0.12*($63K)= $1,940 3$9,500 $9,500- 0.12*($42K)= $4,460 4$9,500 $9,500- 0.12*($21K)= $6,980

28. AW of EVA PW=- $580(P/F12,1)+$1,940(P/F12,1)+$4,460( P/F12,3)+$6,980)P/F12,4) PW=- $580(P/F12,1)+$1,940(P/F12,1)+$4,460( P/F12,3)+$6,980)P/F12,4) AW=PW*(A/P12,4)=$2,844 AW=PW*(A/P12,4)=$2,844

29. Next lecture Dealing with Uncertainty Dealing with Uncertainty Sensitivity Sensitivity Optimistic-Pessimistic Optimistic-Pessimistic