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Www.ischool.drexel.edu INFO 631 Prof. Glenn Booker Week 6 – Chapters 16-18 1INFO631 Week 6.

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Presentation on theme: "Www.ischool.drexel.edu INFO 631 Prof. Glenn Booker Week 6 – Chapters 16-18 1INFO631 Week 6."— Presentation transcript:

1 INFO 631 Prof. Glenn Booker Week 6 – Chapters INFO631 Week 6

2 Income Taxes and After-Tax Cash-Flow Streams Chapter 16 INFO631 Week 6 2 Based on notes from Tockey

3 Income Taxes and After-Tax Cash-Flow Streams Outline Taxes and income taxes, defined Federal income taxes for corporations Effective income tax rates Combining effective federal, state, and local income tax rates Calculating after-tax cash-flow streams Tax credits Inflation and after-tax cash-flow streams 3INFO631 Week 6

4 Tax –E.g., sales tax, property tax, excise tax, … Income tax –Really a tax on net income (aka profit) Taxes A charge, usually of money, imposed by an authority on persons or property for public purposes, or a sum levied on members of an organization to defray expenses 4INFO631 Week 6

5 Why Important? Taxes can have a dramatic effect on profitability –Amount and timing usually know ahead of time Handles as expense in proposal cash-flow stream Income Tax another issue –Do not know how much to pay until know how much profit Rate vary and can be as high as 50% –Including federal, state and local taxes 5INFO631 Week 6

6 US Federal Income Taxes for Corporations Corporation’s Marginal taxable income tax rate $0 to $50,000 15% $50,001 to $75,000 25% $75,001 to $100,000 34% $100,001 to $335,000 39% $335,001 to $10,000,000 34% $10,000,001 to $15,000,000 35% $15,000,001 to $18,333,333 38% Over $18,333,334 35% Tax on net income (revenue – expense) 6INFO631 Week 6

7 Computing Federal Income Taxes for Corporations If taxable income is $450,000 Part of Marginal Tax taxable income tax rate owed First $50,000 15% $7500 Next $25,000 25% $6250 Next $25,000 34% $8500 Next $235,000 39% $91,650 Next $115,000 34% $39,100 Total $153,000 7INFO631 Week 6

8 Federal Marginal Tax Rates Note: Marginal rates are set up to give tax break to companies with < $100,000 income 8INFO631 Week 6

9 Effective Income Tax Rates Average tax rate over a range of incomes Example –What is Effective Tax Rate over range of income between $40k and $60k? At $40k taxable income, tax is $6000 At $60k taxable income, tax is $10,000 9INFO631 Week 6

10 Combining Effective Federal, State, and Local Income Tax Rates State and local income taxes are deductible as expenses on federal returns Example –Effective federal rate is 39% –Effective state and local rate is 7% 10INFO631 Week 6

11 How to address taxes Use before-tax MARR –Accounts for taxes but results might not be accurate enough for decision analysis Use after-tax MARR on after-tax cash flow (recall ch. 10 for more detail). –Example After-tax MARR = (Before-tax MARR) * (1-Eff Tax Rate) E.g. Before-tax MARR = 21%, Eff tax rate = 38% After-tax MARR = 0.21 * (1-0.38) = 0.13 = 13% 11INFO631 Week 6

12 Recall Minimum Attractive Rate of Return (MARR) A statement that the organization is confident it can achieve at least that rate of return Aka “Opportunity cost” –By investing in A, you forego the opportunity to invest in B –If you’re confident you can get X% there, all other alternatives should be evaluated against that X% 12INFO631 Week 6

13 REVIEW - Significance of the MARR The MARR is used as the interest rate in for-profit business decisions –PW(MARR) = how much more, or less, valuable that alternative is than investing same $ in an investment that returns the MARR i.e., PW(MARR) = $1000 doesn’t really mean you’ll gain just $1000, it means that the cash- flow stream is equivalent to $1000 more today than investing those same resources in something that returns the MARR 13INFO631 Week 6

14 REVIEW - Significance of the MARR –Note: MARR is usually set by policy decision from organization’s management team Too high or too low? How set? Impact? 14INFO631 Week 6

15 After Tax Cash Flow Stream How to calculate Need to know four pieces of information –Before-tax cash-flow –Loan principal and interest payments (ch 6) –Depreciation accounting (ch 14) –Effective income tax rate (this chapter) Most straight forward method –Use table on next page Income – positive number Expense – negative number 15INFO631 Week 6

16 Calculating After-Tax Cash-Flow Streams (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 … … N/A … N/A … … … 1 … … … … … … … … 2 … … … … … … … … 3 … … … … … … … … 4 … … … … … … … … 5 … … … … … … … … 16INFO631 Week 6

17 An Example Project (From Ch 3 lecture): Automated Test Equipment (ATE) Assume one person-year of labor = $125k Initial investment –$300k for test hardware and development equipment (Year 0) –20 person-years of software development staff (Year 1) –10 person-years of software development staff (Year 2) Operating and maintenance costs –$30k per year for test hardware and dev equipment (Years 1-10) –5 person-years of software maintenance staff (Years 3-10) Sales income –None Cost avoidance –$1.3 million in reduced factory staffing (Years 2-10) Salvage value –Negligible 17INFO631 Week 6

18 The ATE Example – Cash Flow Stream -$300K -$2.53M $20K $645K Example from Ch 3 Lecture Slides 18INFO631 Week 6 To get to the next slide, assume: Loan is ($250k, 8%, 5 year, annual pmts) depreciable investment ($300K hardware) depreciation method (MACRS, 5 year) Effective income tax rate (36%) company profitable overall

19 After-Tax Cash-Flow Stream for ATE (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 $0 $250K N/A -$300K N/A $0 $0 -$50K 1 -$2.53M -$43K -$20K -$60K -$2.61M $937K -$1.65M 2 $20K -$46K -$17K -$96K -$93K $33K -$9K 3 $645K -$50K -$13K -$58K $574K -$207K $376K 4 $645K -$54K -$9K -$35K $601K -$216K $366K 5 $645K -$58K -$5K -$35K $605K -$218K $365K 6 $645K -$17K $628K -$226K $419K 7 $645K $645K -$232K $413K 8 $645K $645K -$232K $413K 9 $645K $645K -$232K $413K 10 $645K $645K -$232K $413K 19INFO631 Week 6

20 At a given effective income tax rate, each additional dollar of income gives (before tax) –E.g., at 36% effective income tax rate Tax credits, in contrast, are added directly to the after-tax cash-flow stream –$1 in tax credit gives $1 in after-tax income Tax Credits $1.00 – (Effective income tax rate as cents) of additional after-tax income $1.00 – (0.36) = $0.64 Note: Currently there are no tax credits for software related activities 20INFO631 Week 6

21 Tax Credits Purpose –Used to stimulate investment in a particular area of economy Example –Next slide –$300k investment at EOY0 leads to $30k investment tax credit, EOY0 after-tax cash- flow instance -$50k +$30k  -$20k Compared to slide 19 See underlined area on next slide 21INFO631 Week 6 EOY0 = end of year zero

22 After-Tax Cash-Flow Stream with 10% Investment Credit (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 $0 $250K N/A -$300K N/A $0 $0 -$20K 1 -$2.53M -$43K -$20K -$60K -$2.61M $937K -$1.65M 2 $20K -$46K -$17K -$96K -$93K $33K -$9K 3 $645K -$50K -$13K -$58K $574K -$207K $376K 4 $645K -$54K -$9K -$35K $601K -$216K $366K 5 $645K -$58K -$5K -$35K $605K -$218K $365K 6 $645K -$17K $628K -$226K $419K 7 $645K $645K -$232K $413K 8 $645K $645K -$232K $413K 9 $645K $645K -$232K $413K 10 $645K $645K -$232K $413K NOTE $300k investment at EOY0 leads to $30k investment tax credit, EOY0 after-tax cash-flow instance - $50k  -$20k 22INFO631 Week 6

23 Some cash-flow components are affected by inflation … –Revenues, O&M costs, future salvage values, etc. … and some are not –Loan repayment schedules, lease fees, depreciation amounts, etc. When calculating after-tax cash-flows from before-tax cash-flows, use actual dollar analysis –Separate constant dollar components from actual dollar components and apply inflation adjustments only to actual dollar components Inflation and After-Tax Cash-Flow Streams 23INFO631 Week 6

24 Recall - Accounting for Inflation (Ch 13) Actual dollar analysis –Cash-flow instances represent actual out-of- pocket dollars paid/received at that time –Aka current dollars, escalated dollars, inflated dollars, … Constant dollar analysis –Cash-flow instances represent hypothetical constant purchasing power amounts –Aka real dollars, deflated dollars, today’s dollars, … Two Methods 24INFO631 Week 6

25 REVIEW - Actual-Constant Dollar Analogy 25INFO631 Week 6 Does this analogy help anyone? Just curious…

26 Key Points Most taxes can be estimated beforehand, income taxes cannot “Income tax” is really a tax on profit Federal tax rates are “marginal rates” Effective income tax rates approximate actual income tax rates over ranges of taxable incomes (to simplify computations) State and local income taxes are deductible from federal income taxes A table for calculating after-tax cash-flow streams is helpful Tax credits add directly to after-tax income Inflation affects elements of cash-flow streams differently 26INFO631 Week 6

27 Consequences of Income Taxes on Business Decisions Chapter 17 INFO631 Week 627 Based on notes from Tockey

28 Consequences of Income Taxes Outline Additional Areas that may be impacted by income taxes –Interest expenses and income taxes –Interest income and income taxes –Depreciation method and income taxes –Depreciation recovery period and income taxes –Capital gains and losses for corporations –Gain or loss when selling or scrapping depreciable assets –Comparing financing methods in after-tax cash-flow terms –After-tax analysis of replacements 28INFO631 Week 6

29 Most loan interest is deductible –Effectively reduces the interest rate Example –P-Systems and Q-Soft have identical incomes ($465k) and all other expenses –P-Systems averages $200k in loans at 9%, Q-Soft has no loans Interest Expenses and Income Taxes P-Systems Q-Soft Income before interest deduction $465,000 $465,000 Interest expense $18,000 $0 Taxable income $447,000 $465,000 Taxes (effective rate, 36%) $160,920 $167,400 29INFO631 Week 6

30 Interest Expenses and Income Taxes (cont) P-Systems pays $6480 less income tax –Subtracting this from their interest expense means P-Systems effectively paid only $11,520 in interest In general $11,520 $200,000 = = 5.76% EffectiveAfterTaxInterestRate = (1-EffectiveIncomeTaxRate) * LoanInterestRate P-Systems’ EffectiveAfterTaxInterestRate = (1-36%) * 9% = 5.76% Result: When interest rates are tax deductible, borrowing money might not be quite as expensive.

31 Most interest income (loan) is considered taxable –Interest from municipal bonds is an exception Usually exempt from federal income tax Two bonds to compare (more in Ch 18) –$10k municipal bond at 9% –$10k corporate bond at 12% –Buyer’s effective income tax rate = 35% Interest Income and Income Taxes 31INFO631 Week 6

32 Comparing in pre-tax terms –IRR of $10k corporate bond is 12% –IRR of $10k municipal bond is 9% Comparing in post-tax terms –Corporate bond’s $1200 interest is taxed at 35%, or $420 Actual after-tax income is $780 –After-tax IRR of $10k corporate bond is 7.8% –After-tax IRR of $10k municipal bond is still 9% Interest Income and Income Taxes (cont) Result: “Income taxes can significantly impact the desirability of alternatives” 32INFO631 Week 6

33 Depreciation method (Ch 14) will affect the after-tax cash-flow stream –Two depreciation methods Straight-line 150% declining balance switch to straight line Example –Q-Soft is starting a new ASP line of business –7 year planning horizon –Non-depreciable cash-flow stream shown –$120K of depreciable expenses, 5 year useful life –No borrowing –Profitable overall –Effective income tax rate is 38% –After-tax MARR is 17% Depreciation Method and Income Taxes 33INFO631 Week 6

34 After Tax Cash Flow 5-Year Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$24K -$4K $1.5K $21.5K 2 $40K -$24K $16K -$6.1K $33.9K 3 $80K -$24K $56K -$21.3K $58.7K 4 $90K -$24K $66K -$25.1K $64.9K 5 $70K -$24K $46K -$17.4K $52.5K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K 34INFO631 Week 6

35 After Tax Cash Flow 150% Declining-Balance Switching to Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$36.0K -$16K $6.1K $26.1K 2 $40K -$25.2K $15K -$5.6K $34.4K 3 $80K -$24.0K $56K -$21.3K $58.7K 4 $90K -$24.0K $66K -$25.1K $64.9K 5 $70K -$10.8K $59K -$22.5K $47.5K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K 35INFO631 Week 6

36 Comparing Depreciation Methods After Taxes Straight 150% Declining-balance line switching to straight-line PW(17) of the depreciation amounts -$76,784 -$81,897 PW(17) of the income tax payments -$33,791 -$31,848 PW(17) of the after-tax cash flow stream $1040 $2983 After tax IRR 17.25% 17.74% NOTE: Which is better? Why? From after tax perspective % switching to straight - More tax dollars avoided earlier, just from changing depreciation strategy 36INFO631 Week 6

37 Depreciation recovery period also affects the after-tax cash-flow stream –In general it is better to write off more dollars sooner from an after-tax perspective –Shorter recovery periods better than long ones –Note: Might lead to higher taxes in later years, but PW of after-tax cash-flow stream will be greater Try the same Q-Soft example with 3-year straight-line depreciation Depreciation Recovery Period and Income Taxes 37INFO631 Week 6

38 3-Year Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$40K -$20K $7.6K $27.6K 2 $40K -$40K $0K $0.0K $40.0K 3 $80K -$40K $40K -$15.2K $64.8K 4 $90K $90K -$34.2K $55.8K 5 $70K $70K -$26.6K $43.4K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K 38INFO631 Week 6

39 Comparing Depreciation Recovery Periods After Taxes 5-year 3-Year straight-line straight-line PW(17) of the depreciation amounts -$76,784 -$88,383 PW(17) of the income tax payments -$33,791 -$29,383 PW(17) of the after-tax cash flow stream $1040 $16,324 After tax IRR 17.25% 20.86% NOTE: 3-year higher PW of depreciation amounts and lower PW income taxes because of accelerated write offs PW of after tax cash-flow stream and IRR favor 3-year Conclusion: from after-tax perspective the sooner you can write off, the better 39INFO631 Week 6 From slide 34

40 Ordinary income comes from activity –Capital gain comes from increase in value without explicit activity –Capital loss is opposite “Short-term” gains are <1 year –Long-term gains are >1 year –Taxes on short-term and long-term gains may be different Capital Gains and Losses for Corporations 40INFO631 Week 6

41 Recently, capital gains were taxed like ordinary income but with a 34% limit –Capital gains could be taxed at less than, or equal to, 34%, but not more Examples ( See Income tax rates Ch 16) –AlphaSystems has $55k of ordinary income and $20k of capital gain, capital gain would be taxed at 25% –BetaSystems has $80k of ordinary income and $20k of capital gain, capital gain would be taxed at 34% –GammaSystems has $180k of ordinary income and $20k of capital gain, capital gain would be taxed at 34% (even though GammaSoft is otherwise in a 39% bracket) Capital Gains and Losses for Corporations (cont) 41INFO631 Week 6

42 May be restrictions on addressing capital losses –Only usable to offset capital gains –Can carry capital losses back up to 3 years, carry forward up to 5 This is why politicians make such a big deal about capital gains taxes! Examples –DeltaSystems has no ordinary income, $10k of capital loss this year, and $20k of capital gain last year  amend last year’s tax return to only $10k of capital gain –ThetaSystems has no ordinary income, $10k of capital loss this year, and no capital gain for last 3 years  capital loss is held in reserve against future gains for up to 5 years Capital Gains and Losses for Corporations (more) 42INFO631 Week 6

43 When a depreciable asset is sold or scrapped, the difference between its book value and amount received needs to be addressed –Amounts less than book value subtract from ordinary income –Amounts greater than book value add to ordinary income (“depreciation recapture”) Gain or Loss When Selling or Scrapping Depreciable Assets 43INFO631 Week 6

44 When buy asset –Three ways of paying for assets Buy with retained earnings –Buy with money already earned as profit –Owned entirely by company –All tax benefits from ownership is available Buy with a loan –Borrow all or part of acquisition costs Lease –Lease fee’s deductible as ordinary expense –Tax consequences are different for each Comparing Financing Methods in After-Tax Cash-Flow Terms 44INFO631 Week 6

45 Example: OmegaSoft buys $60k in equipment to support ASP service –$9000 annual operating and maintenance costs –7 year planning horizon –MACRS 5 year depreciation –OmegaSoft is profitable overall –Effective income tax rate is 43% –After-tax MARR is 10% Comparing Financing Methods in After-Tax Cash-Flow Terms 45INFO631 Week 6

46 Buy With Retained Earnings (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 0.0K N/A -$60K N/A $0K $0K -$60.0K 1 -$9.0K -$12.0K -$21.0K $9.0K $0.0K 2 -$9.0K -$19.2K -$28.2K $12.1K $3.1K 3 -$9.0K -$11.5K -$20.5K $8.8K -$0.2K 4 -$9.0K -$6.9K -$15.9K $6.8K -$2.2K 5 -$9.0K -$6.9K -$15.9K $6.8K -$2.2K 6 -$9.0K -$3.5K -$12.5K $5.4K -$3.6K 7 -$9.0K -$9.0K $3.9K -$5.1K 46INFO631 Week 6

47 Buy With 13% Loan (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 0.0K $60K N/A -$60K N/A $0K $0K $0.0K 1 -$9.0K -$5.8K -$7.8K -$12.0K -$28.8K $12.4K -$10.2K 2 -$9.0K -$6.5K -$7.1K -$19.2K -$35.3K $15.2K -$7.4K 3 -$9.0K -$7.4K -$6.2K -$11.5K -$26.7K $11.5K -$11.1K 4 -$9.0K -$8.3K -$5.2K -$6.9K -$21.1K $9.1K -$13.4K 5 -$9.0K -$9.4K -$4.2K -$6.9K -$20.1K $8.6K -$14.0K 6 -$9.0K -$10.6K -$2.9K -$3.5K -$15.4K $6.6K -$15.9K 7 -$9.0K -$12.0K -$1.6K -$10.6K $4.6K -$18.0K Note: $60k loan, 13%, 7 years, annual payments 47INFO631 Week 6

48 Lease (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$12.0K N/A N/A -$12.0K $5.2K -$6.8K 1 -$21.0K -$21.0K $9.0K -$12.0K 2 -$21.0K -$21.0K $9.0K -$12.0K 3 -$21.0K -$21.0K $9.0K -$12.0K 4 -$21.0K -$21.0K $9.0K -$12.0K 5 -$21.0K -$21.0K $9.0K -$12.0K 6 -$21.0K -$21.0K $9.0K -$12.0K 7 -$9.0K -$9.0K $3.9K -$5.1K Note: $12K annual lease payments at end of all but last year 48INFO631 Week 6

49 Comparing Financing Methods After Taxes PW(10%) Buy with retained earnings -$59,116 Buy with loan -$54,393 Lease -$56,005 Note: Looking at expenses only since this is a service alternative. 49INFO631 Week 6

50 Loans, Interest Rates, and MARRs In prior example, why borrow at 13% when MARR is 10%? –In this example loan interest rate is before-tax and MARR is after-tax When effective tax rate is 43%, actual after-tax cost of borrowing is At an effective income tax rate of 43%, a 10% after-tax loan interest rate is equivalent to a before-tax loan interest rate of 50INFO631 Week 6

51 Buy With 17.5% Loan (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 0.0K $60K N/A -$60K N/A $0K $0K $0.0K 1 -$9.0K -$5.0K -$10.5K -$12.0K -$31.5K $13.5K -$11.0K 2 -$9.0K -$6.0K -$9.6K -$19.2K -$37.8K $16.3K -$8.3K 3 -$9.0K -$6.9K -$8.6K -$11.5K -$29.1K $12.5K -$12.0K 4 -$9.0K -$8.1K -$7.4K -$6.9K -$23.3K $10.0K -$14.5K 5 -$9.0K -$9.6K -$6.0K -$6.9K -$21.9K $9.4K -$15.2K 6 -$9.0K -$11.2K -$4.3K -$3.5K -$16.8K $7.2K -$17.3K 7 -$9.0K -$13.2K -$2.3K -$11.3K $4.9K -$19.6K Note: $60k loan, 17.5%, 7 years, annual payments 51INFO631 Week 6

52 Loans, Interest Rates, and MARRs (cont) PW(10%) Buy with retained earnings -$59,116 Buy with 17.5% loan -$59,101  Conclusion: As long as the after-tax loan interest rate is less than the after-tax MARR, buying with a loan is better than buying with retained earnings Because MARR represents opportunity cost, buying with retained earnings prevents opportunity to MARR. As long as (after-tax loan interest rate) < (after-tax MARR), cost of money used is less. 52INFO631 Week 6

53 Income tax has special effects on replacement decisions –Existing assets (defenders) Defer possible depreciation recapture –Replacement alternatives (challengers) Might lead to tax credits Need depreciation schedules determined Replacement analysis needs to be done in after-tax terms to avoid making a wrong decision After-Tax Analysis of Replacements 53INFO631 Week 6

54 Key Points Deducting loan interest effectively reduces the loan interest rate Interest income is usually considered taxable income Depreciation methods that allow you to write off more of the value sooner are better Shorter depreciation recovery periods are also better Capital gain comes from an increase in the value of something and can affect taxes 54INFO631 Week 6

55 Key Points When a depreciable asset is sold or scrapped, any difference between its book value and the actual amount received needs to be accounted for in the corporation’s income taxes Buying with retained earnings, a loan, or leasing affects the after-tax cash flow stream –Buying with a loan may actually be the least expensive After-tax replacement analysis should address depreciation recapture for existing assets, depreciation accounting for new assets, and potential tax credits 55INFO631 Week 6

56 Not-for-profit Business Decisions Chapter 18 INFO631 Week 656 Based on notes from Tockey

57 Not-For-Profit Business Decisions Outline Introducing not-for-profit decisions Software and governments Software and nonprofit organizations Benefit-cost analysis for single proposals Benefit-cost analysis for multiple proposals Cost effectiveness analysis 57INFO631 Week 6

58 For-profit decision techniques don’t apply when the organization’s goal isn’t profit –E.g., government and nonprofit organizations Not-for-profits have different goals, so different decision techniques are needed –Benefit-cost analysis –Cost-effectiveness analysis Introducing Not-for-profit Decisions 58INFO631 Week 6

59 “But the government doesn’t do software” –The Department of Defense (DoD) is probably the single largest customer of software development in the US –The U. S. Internal Revenue Service (IRS) has been processing Form 1040s by computer since the early 1980’s –Many state and local agencies have been moving toward computer-based support of 911 emergency call centers, welfare administration, public schools, … –Some states, counties, and larger cities are using Enterprise Resource Planning (ERP) packages for payroll, inventory management, and so on With each passing year, more and more software is being used (and developed) in the public sector Software and Governments 59INFO631 Week 6

60 According to the U. S. Constitution, two primary drivers of the U. S. Federal Government: –National defense –General welfare of the population Smaller government units (states, counties, and cities) should follow this same general objective –Maximize the general welfare of the constituents in that unit The Aim of Government 60INFO631 Week 6

61 Public activities tend to be inherently inefficient –Government services are hard to put a dollar value on What is the value of a fire department, a jail, an elementary school, etc? –Government projects tend to serve more than one purpose A dam is both –New power source –New recreational facility –When services are paid for (taxes) People’s use might be disconnected from when those services are received –You might not pay for service when you receive it –Hard to associate value of money spent –Where do property tax dollars go? The Nature of Public Activities 61INFO631 Week 6

62 Public activities tend to be inherently inefficient –Lack of correlation between the benefits any one person gets and how much he or she pays for them Taxation is often based on ability to pay Spending is based on equalizing opportunity –The government is the sole provider of many services Lack of competition  no need to worry about efficient use of taxpayer funds The Nature of Public Activities 62INFO631 Week 6

63 Taxes –Corporate income, individual income, property, excise, estate, import duties,... Fee-for-use –Post Office, public utilities like power and water, government-run parks and museums, etc. Bonds –Like an interest-only loan how much to borrow, how long, etc. –Types General obligation bond –Backed by ability to tax Revenue bond –Backed by anticipated income from project Financing Government Activities 63INFO631 Week 6

64 Cash-flow Diagram for a Bond CFD for a 10-year, $5000 bond at 8%. 64INFO631 Week 6

65 More and more nonprofit organizations are either using commercial software or are developing their own The goal is to increase the general welfare of a given population –The Object Management Group (OMG) develops “technically excellent, commercially viable and vendor independent specifications for the software industry” –Institute for Electrical and Electronics Engineers (IEEE) –Association for Computing Machinery (ACM) –Internet Engineering Task Force (IETF), part of The Internet Society (ISOC) –Software Productivity Consortium (SPC) Nonprofit organizations are typically financed through membership fees, fee-for-use, donations, and (in some cases) government grants Software and Nonprofit Organizations 65INFO631 Week 6

66 A rural public utility district (PUD) needs to choose between computerizing its billing system and computerizing inventory management –Has enough money for one of these, but not both PUD can’t base the decision on profit because neither will generate any directly measurable income –Choice needs to be based on which contributes more to the general welfare of the citizens –If PUD can consider the benefits of either in relation to its cost, they can establish a basis for choice –This is the foundation for Benefit-cost Analysis (or cost-benefit analysis) Decision Analysis in Government and Nonprofit Organizations 66INFO631 Week 6

67 One of the most widely used methods for evaluating nonprofit proposals The U. S. Flood Control Act of 1936 is generally acknowledged as the first description of this technique Benefit-Cost Analysis 67INFO631 Week 6

68 “It is hereby recognized that destructive floods upon the rivers of the United States, upsetting orderly processes and causing loss of life and property, including the erosion of lands, and impairing and obstructing navigation, highways, railroads, and other channels of commerce between the States, constitute a menace to national welfare; that it is the sense of Congress that flood control on navigable waters or their tributaries is a proper activity of the Federal Government in cooperation with the States, their political subdivisions, and localities thereof; that investigations and improvements of rivers and other waterways, including watersheds thereof, for flood-control purposes are in the interest of the general welfare; that the Federal Government should improve or participate in the improvement of navigable waters or their tributaries, including watersheds thereof, for flood control purposes if the benefits to whomsoever they may accrue are in excess of the estimated costs, and if the lives and social security of people are otherwise adversely affected” Flood Control Act of INFO631 Week 6

69 “ Benefits to whomsoever they may accrue” –Measurable advantages to the population caused by the proposal, minus any measurable “dis-benefits” –Always in the context of that population Costs –All expenses, minus all savings, incurred by the sponsor –Includes initial investment and ongoing operating and maintenance costs –Always in the context of the sponsor Cost savings aren’t benefits to the population; they are reductions in expenses to the sponsor –Adding an amount to the numerator does not have the same effect as subtracting the same amount from the denominator Incorrect accounting of sponsor savings can result in misleading benefit-cost ratios Benefit-Cost Analysis for a Single Proposal 69INFO631 Week 6

70 Benefit-Cost Analysis for a Single Proposal Benefits and costs can be expressed in any basis for comparison –PW(i), AE(i), FW(i),... –Use same basis for both Comparing PW(i) benefits to AE(i) costs would be extremely misleading A proposal is only desirable when its net benefits are greater than its net costs Leads to idea of benefit-cost ratio: or 70INFO631 Week 6

71 Any proposal with BC(i) < 1 can usually be discarded without further analysis –It costs more than it would benefit –Only reason to continue would be when there are overriding irreducible benefits or the investment is mandated for some other reason (e.g. legislation) Proposals should also be discarded if the initial investment can’t be afforded –A proposal with an enormous BC(i) is irrelevant if the initial investment is too high Benefit-Cost Analysis for a Single Proposal 71INFO631 Week 6

72 Important when analyzing proposal Points of view are typically based on: –Geography—everybody who lives or works in some particular area –Social groups—peoples interested in some particular issue –Organizations—members of a particular group (e.g., union) –Products or markets—e.g., agricultural markets, fisheries markets, etc. –... Proper Point of View 72INFO631 Week 6

73 Identify everyone who would: –Benefit from the proposal Utility customers—bills would be more accurate and timely, less likely to have their payment lost or forgotten –Be adversely impacted by the proposal PUD managers or clerks could lose their jobs because computerization makes them no longer necessary –Pay for the proposal PUD would pay for the proposal Part might be paid through state or federal grants Proper Point of View 73INFO631 Week 6

74 Don’t analyze benefits and costs before and after the proposal –There may have been changes independent of the proposal Evaluate benefits and costs with and without the proposal –Only changes caused by the proposal itself are important in benefit-cost analysis All benefits and costs that have a market value need to be represented in terms of money –Those that don’t have market value should also be included (“irreducibles” in Chapter 4) Identifying Benefits, Dis-Benefits, and Costs 74INFO631 Week 6

75 Primary benefits represent value to the public of direct products or services from the proposal –U. S. Federal Aviation Administration’s (FAA) Air Traffic Modernization program intends to support more airplanes and allow more fuel-efficient routing Identifying Benefits, Dis-Benefits; Two Types 75INFO631 Week 6

76 Secondary benefits are additional products and services gained from the activities of, or stimulated by, the project –Commercial hand-held Global Positioning System (GPS) is a secondary benefit of military investment in navigation –National Aeronautics and Space Administration (NASA) space program has led to secondary benefits like: World-wide communication, satellite imagery, climate research and long-range weather forecasting, high- density batteries, solar cells, advanced materials and structural designs, advanced food processing and waste purification systems, … Identifying Benefits, Dis-Benefits; Two Types 76INFO631 Week 6

77 If component has a market price, that price might be appropriate way to value the component –Market price isn’t always accurate because of subsidies, price supports, or restraints Find the least expensive way to provide that same service Valuing Benefits, Dis-Benefits, Costs, and Savings 77INFO631 Week 6

78 Estimate what a user is willing to pay by seeing how much he/she spends to take advantage of it –Common method for finding the “value” of recreational facilities like parks is to multiply the expected number of visitors by the anticipated entrance fee Could be impossible to assign some values –Inappropriate to value fish in a river by multiplying the estimated pounds of it by the market price of that kind of fish Valuing Benefits, Dis-Benefits, Costs, and Savings 78INFO631 Week 6

79 PUD estimates customers spend hundreds of hours each year fixing billing problems –Considering average income for customers and annual increase in customers, PUD estimates this is worth $42,000 in AE(i) terms –Some customers will need to buy computers and pay ISP connection fees estimated at $3000 in AE(i) terms –AE(i) net benefits to public are $39,000 PUD estimates hardware and software costs for both acquisition and support, in AE(i) terms, are $44,000 –PUD billing department is overworked, combining annual overtime bill with growth rate in customers, estimates savings are $7000 in AE(i) terms –PUD also estimates that reduction in missing and late payments each year, in light of annual growth rate, will be worth $3,000 in AE(i) terms –AE(i) net cost to PUD is $34,000 BC(i) = $39,000 / $34,000 = 1.15 –BC(i) > 1.00 so this proposal is worth considering further Valuing Benefits, Dis-Benefits, Costs, and Savings Example – 10 year planning horizon 79INFO631 Week 6

80 Benefits and costs need to be expressed in a common form –PW(i), FW(i), AE(i), … The interest rate used needs to reflect the actual cost of money –For a government agency, this could be the interest rate on bonds issued to finance the project –Another way is to look at the rate that could have been earned by the citizens if the money hadn’t been removed from the private sector Use the more appropriate rate in any particular situation Choosing an Interest Rate 80INFO631 Week 6

81 Unless there is some overriding reason, a proposal with BC(i) <= 1.00 should be dropped If the organization can’t afford the proposal’s initial investment, the benefit is irrelevant –Proposals should be dropped here, too If PUD can afford the initial investment in the billing computerization proposal, its BC(i) = 1.15 means this project deserves further investigation Summarizing Benefit-Cost Analysis for Single Proposals 81INFO631 Week 6

82 May be possible to carry out more than one proposal at a time –May also have dependencies among proposals Use Chapter 9 process to build mutually exclusive alternatives –Dependencies, exclusivities, budget constraints, etc –Benefits for an alternative will be sum of benefits for all proposals in that alternative –Costs will be sum of costs for all proposals in that alternative –All benefits and costs need to be in the same terms, PW(i), FW(i), AE(i), … Benefit-Cost Analysis for Multiple Proposals 82INFO631 Week 6

83 Table shows PW(i) benefits, PW(i) costs, and BC(i) for four mutually-exclusive alternatives –A2 looks best because it has highest BC(i) Benefit-cost analysis with multiple alternatives must be done incrementally –Don’t think of highest overall BC(i) –Think of the incremental benefit gained from an avoidable increment of cost Multiple BC(i) Requires Incremental Analysis Alternative PW(i) Benefits PW(i) Costs BC(i) A1 $136,500 $68, A2 125,200 59, A3 71,200 37, A4 86,300 58, INFO631 Week 6

84 Incremental Analysis for Multiple BC(i) Alternatives Sort alternatives in order of increasing cost Alternative with lowest cost is defender {* As long as proposals with BC(i) < 1 have been discarded, you can skip the A0 (do nothing) alternative *} Repeat Alternative with next lowest cost is challenger Incremental benefit = challenger benefit - defender benefit Incremental cost = challenger cost - defender cost Incremental BC(i) = incremental benefit / incremental cost If incremental BC(i) > 1.0 then challenger becomes defender Until there are no more alternatives 84INFO631 Week 6

85 Sort alternatives in order of increasing costs –A3, A4, A2, A1 (assuming all proposals have BC(i) > 1.0) First incremental choice is between A3 and A4 –Incremental BC(i) <= 1.0, A3 remains defender Next incremental choice is between A3 and A2 –Incremental BC(i) > 1.0, A2 becomes defender Last incremental choice is between A2 and A1 –Incremental BC(i) > 1.0 so A1 is best Incremental Analysis for Multiple BC(i) Alternatives—Example $86,300 - $71,200 $15,100 $58,900 - $37,500 $21,400 BC(i) = = = 0.71 $125,200 - $71,200 $87,700 $59,600 - $37,500 $22,100 BC(i) = = = 4.00 $136,500 - $125,200 $11,300 $68,600 - $59,600 $9,000 BC(i) = = = INFO631 Week 6

86 Explaining Incremental BC(i) Analysis Incremental BC(i) A2A1 Cost Benefit INFO631 Week 6

87 Originated in the defense and space community –Informally, “getting the biggest bang for the buck” Shares same philosophy and methodology with BC(i) analysis –Derived from benefit-cost analysis Three requirements for using Cost-effectiveness Analysis: –Problem must be bounded –More than one possible solution to that problem –Proposals are all valid solutions to that problem Cost-Effectiveness Analysis 87INFO631 Week 6

88 Two versions of cost-effectiveness analysis –Fixed-cost maximizes benefit given an upper bound on cost Many software projects have a fixed Software Quality Assurance (SQA) budget: plan and execute SQA within that budget to maximize the probability of uncovering software defects This is, literally, the biggest-bang-for-the-buck approach –Fixed-effectiveness minimizes cost given a lower bound on effectiveness In SQA this would mean planning and executing to get the required level of reliability for the least cost Safety-critical or mission-critical software is more likely to use this approach Cost-Effectiveness Analysis (cont) 88INFO631 Week 6

89 Measures of effectiveness need not be dollars –In fact they probably won’t be –If effectiveness could be measured in dollars then the analysis could be done with Benefit-cost analysis Examples –SQA group may define effectiveness as defects found before the software is released to customer –Number of controlled files handled by a revision control system might be a measure of effectiveness Measure of effectiveness needs to be relevant to the organization Measures of Effectiveness 89INFO631 Week 6

90 1.Define goal(s) 2.Develop proposals that achieve goal(s) 1.Use optimum configurations for each alternative 3.Establish evaluation criteria for both cost and effectiveness 1.May be other evaluation criteria in addition to cost and effectiveness 2.Evaluation criteria should be prioritized 4.Choose fixed-cost or fixed-effectiveness approach 5.Analyze alternatives against evaluation criteria 1.Candidates that exceed fixed-cost or fall short of fixed- effectiveness can be dropped 2.Analyze remaining candidates in more detail to make final choice Steps in Cost-Effectiveness Analysis 90INFO631 Week 6

91 1.Goal: find best inventory management software for PUD 2.Proposals: buy from V1, buy from V2, lease from V3, build in-house 3.Evaluation criteria are cost and amount of inventory managed 4.Choose fixed-cost or fixed-effectiveness (key choice!) Example Cost-Effectiveness Analysis Proposal PW(i) Cost Amount of inventory Buy V1 $256K 565K Buy V2 455K 790K Lease V3 242K 580K Build 420K 680K 91INFO631 Week 6

92 Assume maximum budget of $300K Analyze remaining candidates in more detail to make final choice –Buy from V1 has 565K units for $256K = 2.2 units/$ –Lease from V3 has 580K units for $242K = 2.4 units/$ –Choose lease from V3 (more stuff per $) Fixed-Cost Example Proposal PW(i) Cost Amount of inventory Buy V1 $256K 565K Buy V2 455K 790K Lease V3 242K 580K Build 420K 680K 92INFO631 Week 6

93 Assume minimum effectiveness of 650K units Analyze remaining candidates in more detail to make final choice –Buy from V2 has 790K units for $455K = 1.7 units/$ –Build produces 680K units for $420K = 1.6 units/$ –Choose buy from V2 Fixed-Effectiveness Example Proposal PW(i) Cost Amount of inventory Buy V1 $256K 565K Buy V2 455K 790K Lease V3 242K 580K Build 420K 680K 93INFO631 Week 6

94 Key Points Government isn’t driven by profit, neither are non-profit organizations –Goal is to promote general welfare of respective populations –Decision techniques need to be different Benefit-cost analysis is one of most widely used methods –A proposal is only desirable when net benefits > net costs –Analysis of multiple proposals must be done incrementally Two versions of cost-effectiveness analysis: fixed-cost and fixed-effectiveness –Fixed-cost analysis maximizes benefit given upper bound on cost –Fixed-effectiveness analysis minimizes cost needed to achieve a lower bound on benefit 94INFO631 Week 6


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