1. 12/22/2015rd1 Engineering Economic Analysis Chapter 12  Income Taxes

2. 12/22/2015rd2 Taxes The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.-Amendment XVI, U.S. Constitution It takes only a majority to institute the Fair Tax but a 2/3 vote to repeal an amendment. Thus it is possible to have the Fair Tax enacted with continued taxation under the current IRS.

3. Personal Income Personal Exemptions $3400 Itemized deductions Excessive medical and dental exceeding 1.5% of AGI State and local tax Home mortgage interest Charitable donations Casualty and theft losses (> $100 + 10% AGI) Miscellaneous deductions (> 2% of AGI) Car and other business expenses Tax benefits for work-related education Standard Deduction Single taxpayer $5350 Married filing jointly ($10,700) Taxable income = AGI – PE – Itemized-deduct or Standard Deduction 12/22/2015rd3

4. Taxes Income Property Sales Excise 12/22/2015rd4

5. Classification of Business Expenditures Capital Expenditures Depreciable assets Non-depreciable assets Expensed All other business expenditures Taxable income = GI – Expensed - Depreciation 12/22/2015rd5

6. 12/22/2015rd6 Item Gross income ~ total income from all revenue producing sources Expenses ~ all corporate costs incurred in the business Cost of goods sold Depreciation Operating expenses Taxable operating income ~ amount on which taxes are assessed Income taxes ~ amount of taxes based on some form of income Net income Corporate Taxes

7. 12/22/2015rd7 Corporate Tax Rate Taxable IncomeTax RateCorporate Income tax Not over $50K15%15% over $0 7500 $50K-75K25%$7.5K+25% over $50K 6250 $75K-100K34%$13.75K+34% over $75K 8500 $100K-335K39%$22.25K+39% over $100K 91650 $335K-10M34%$113.9K+34% over $335K 3.2861M $10M-15M35%$3.4M+35% over $10M 1.75M $15M-18.3M38%5.150M+38% over $15M 1.254M $18.3M and up35%6.416666 + 0.35% over 18.3M

8. 12/22/2015rd8 Taxable Income Year 1Year 2Year 3 Gross Income$200$200$200 Special Tooling -60 0 0 (3-year life) Expenditures -140 -140-140 Cash results $0 $60$60 Use st line depreciation with 0 salvage to get 60/3 = $20 Taxable Income$40$40$40 Computed as (200 – 20 – 140) = $40 to show that taxable income is a better indicator of performance

9. 12/22/2015rd9 Computing Corporate Tax A corporation buys a $75K machine that for the first year brings in $200K of revenue with $84K operating expenses and $4K of depreciation. Compute taxes paid at 30% rate and net income. How much was generated from operations? Taxable income = GI – Expensed – Depreciation = 200K – 84K – 4K = 112K Taxes = 112K * 0.30 = $33.6K taxes paid => Net Income = Taxable Income * 0.70 = 112K * 0.7 = $78.4K $78.4K + 4K = $82.4K generated from operations.

10. 12/22/2015rd10 Corporate Tax Given a boat was bought for $80K with a 10-year life and $10K salvage value. First year operating expenses and revenues show Operating revenue$250,000 Operating expenses $90,000 Depreciation $7,000 If the company’s tax rate is 34%, compute the net income for the first year. (250K – 90K – 7K) * 0.66 = $100,980

11. 12/22/2015rd11 Corporate Tax Taxable IncomeTax RateCorporate Income tax Not over $50K15%15% over $0 $50K-75K25%$7.5K+25% (X - $50K) $75K-100K34%$13.75K+34%(X – $75K) Compute the effective tax rate and marginal tax rate for a firm with taxable income of $90,000. Taxes paid = 0.15(50K) + 0.25(25K) + 0.34(15K) = $18,850 = 13.75K + 0.34(90K – 75K) = $18,850 Effective tax = 18,850 / 90,000 = 20.94%; marginal tax rate = 34% Effective rate is also called the average tax rate.

12. 12/22/2015rd12 MACRS Depreciation A 5-year MACRS tool costing $60K has calculated salvage values of $20K in year 3, $10K in year 5 and $5K in year 6. Compute the gain or loss if disposed of in years 3, 5 and 6. DC 3 = $60K(0.2 + 0.32 + 0.192/2) = $36,960 => BV 3 = $23,040 Loss = 20K – 23,040 = -$3,040 DC 5 = $60K(0.2 + 0.32 + 0.192 + 0.1152 + 0.1152/2) = $53,088 BV 5 = $60K – 53,088 = $6,912 => Gain = 10K - $6,912 = $3,088. DC 6 = $60K with BV 6 = 0 => Gain is $5K. (macrs 5)  (20.0 32.0 19.2 11.52 11.52 5.76) (Dmacrs 60e3 5)  (12000 19200 11520 6912 6912 3456)

13. 12/22/2015rd13 Federal and State Tax A corporation has $2M in revenue and $1.2M in expenses. If the marginal federal tax rate is 34% and the state rate is 6% compute the combined taxes paid. Taxable Income = $2M – $1.2M = $800K Method I: 0.34 + 0.06 – (0.34 * 0.06) = 37.96% combined F&S $800K * 0.3796 = $303,680. Method II: State Tax = $800K * 0.06 = $ 48,000 Federal tax = (800K – 48K) = 752K (* 0.34) = $255,680 $303,680

14. 12/22/2015rd1412/22/2015rd14 Personal Income Tax 2007 Individual income tax rate schedule for single and married filing jointly Taxable Income$ Tax Rate Filing SingleFiling Married and Jointly 0.10 $0 – 7,825 $0–15,650 0.15 $7,826 – 31,850 $15,651–63,700 0.25 $31,851 – 77,100 $63,701 – 128,500 0.28 $77,101 – 160,850 $128,501 – 195,850 0.33 $160,851 – 349,700 $195,851 – 349,700 0.35 Over $349,700 Over $349,700 a) Compute tax for a single with a taxable income of $55K. Tax = 0.10(7,825) + 0.15(24,024) + 0.25(23,149) = $10,173.35 b) Compute tax for a couple filing jointly with a taxable income of $150K. Tax = 0.1(15,650) + 0.15(48049) + 0.25(64799) + 0.28(150K – 128,501) = $30,991.82 => effective tax rate of 30991.82/150K = 20.66%

15. Personal Income Tax Joe and Holly earn $82K and have 4 personal exemptions and the standard deduction of $9500. Interest & dividends amount to $6050 Gross income = salaries + interest & dividends, capital-g = $82K + 3550 + 2500 = $88,050 Taxable income = gross – exemptions – deductions = 88,050 -4(3100) – 9500 = $66,150. Taxes = 15,651(0.10) + 63,700 – 15,650)0.15 + (66,150 – 63,700)(0.25) = $9385; of which 9385/88050 = 10.7% effective. 12/22/2015rd15

16. 12/22/2015rd16 Income Taxes Find the breakeven number of days for purchasing a truck for $13K with 3K salvage value at end of a 7- year life with $1100 annual expense and $35 daily expense, or lease for $83 a day based on 10% ATCF and 50% tax rate. Use straight line depreciation N BTCF SLine TI 50% Tax ATCF 0 -$13K -$13K 1-7 48X–1100 1428.57 48X–2528.57 –24X+1264.29 24X+164.29 7 30003000 13K(F|P,10%,7) = (24X+164.29)(F|A,10%,7) + 3000 25,333.32 = 226.69X+ 1558.64 +3000 X = 91.61 days

17. 12/22/2015rd17 Income Taxes 12-47. House and lot sell for $155K. Land is $45K and home is $110K. Rent inputs $12K yearly with st-line depreciation 27.5 year life. Mary wants a 10% ATCF. Find selling price at year n = 10 for Mary in 28% tax rate. nBTCFSLNTI28%TaxATCF 0-155K-155K 1-10 12K 110K/27.5 = 4K8K-2.24K 9.76K 10 X (X – 115K) -0.28X + 32.2K 0.72X + 32.2K BV 10 = 155K – 10(4K) = 115K 155K = 9.76K(P/A, 10%, 10) + (0.72X + 32.2K)(P/F, 10%, 10)  X = $297,612.25.

18. 12/22/2015rd18 Incremental ATCF Analysis 12-52 n BTCFDCTI 20% Tax ATCF IRR -25-25 B1-5 7.5 52.5 - 0.50 712.38% -10-10 C1-5 3 21 - 0.202.812.38% -5-5 D1-5 1.7 10.7 - 0.141.5616.92% -15-15 E1-5 5 32 - 0.40 4.616.17% -30-30 F1-5 8.7 61.7 - 0.348.1611.21% MARR = 10%

19. 12/22/2015rd19 Incremental ATCF Analysis D is > MARR; begin incremental analysis in order of cost. C-D (IRR ‘(-5 1.24 1.24 1.24 1.24 1.24))  7.63% E-D (IRR ‘(–10 3.04 3.04 3.04 3.04 3.04))  15.8% E B-E (IRR ‘(-10 2.4 2.4 2.4 2.4 2.4))  6.4% => E F-E (IRR ‘(-15 3.56 3.56 3.56 3.56 3.56))  6% => E E is best. MARR = 10%

20. 12/22/2015rd20 Taxable Income A small company has taxable income of $50K and is thinking of another project which will increase taxable income by $45K. a) Compute the increase in taxes if the project is assumed. b) Repeat analysis if taxable income is $400K. a) (0.15 * 50K) = $7500 without project (under $50 K => 15% tax) With 95K TI 13,750 + (0.34 * 20K) = $20,550 Taking on the $45K project increases taxes by ($20.55K - $7.5K) = $13.05K, implying 13,050/45,000 = 29% of project is taxes. b) 113.9K + (0.34 * 65K) = $136,000 taxes for TI = $400K 136/400 = 34% which is about the same for the additional $45K project. 0.34 * $45K = $15,300 for total tax of $151,300.

21. 12/22/2015rd21 ATCF After-tax Cash flow Gross income (Income less Tax exemptions) Income taxes Interest on borrowed money Deductions other than interest and depreciation

22. After Tax Cash Flow = - P n (capital investments) + S n (revenues from sales of assets) - t(S n - B n ) (taxes on gains from sales of assets) - W(net working capital) + (1 – t)R n (after tax ordinary revenues) -(1 – t)E n (AT operating expenses, labor energy, materials + tD n (depreciation tax savings) -(1 –t)IP n (AT interest payments) -PP n (Principal payments) + B(loans received) 12/22/2015rd22

23. 12/22/2015rd23 Problem 12-21 nBTCF DDBTI46% TaxATCF 0-100K -100K 1 30K 50K-20K 9.2K39.2K 2 30K 25K 5K -2.3K27.7K 3 35K 12.5K22.5K-10.35K24.65K 4 40K 6.25K33.75K-15.525K24.475K 5 10K 010K -4.6K 5.4K 6 10K 010K -4.6K11.65K 6 6.25K 0 Tools sold for salvage value of $6,250 (IRR ‘(-100000 39200 27700 24650 24470 5400 11650))  11.61%

24. 12/22/2015rd24 Loan Payment = $25,237.66 nBTCF DDB P ITI 46% Tax ATCF 0- 20K - 20,000.00 1 30K 50K 17237.66 8000 -28,000 12,880 17,642.34 2 30K 25K 18961.43 6276.23 -1276.23 587.06 5,349.40 3 35K 12.5K 20857.57 4380.09 18,119.91 -8,335.16 1,427.18 4 40K 6.25K 22943.33 2294.33 31,455.67 -14,469.60 292.74 5 10K 0 10,000 - 4,600 5,400.00 6 10K 0 10,000 - 4,600 11,650.00 6 6.25K 0 0 (IRR ‘(-20000 17642.34 5349.40 1427.18 292.74 5400 11650))  34.31%. Problem 12-22

25. Problem 12-39 First cost = $25K, life 4 years, salvage value = $5K, UAB = $8K MARR = 10% in 40% tax bracket, MACRS 3 n BTCF Dep TI Tax (40%) ATCF 0 -25K-25K 1 8K 8333 -333 133.208133.2 2 8K 11112 -3112 1244.89244.8 3 8K 3702 4292 -1719.206280.8 4 8K 1852 6148 -2459.205540.80 + 5K (list-pgf '(-25e3 8133.2 9244.8 6280.8 10540.8) 10)  $1952.51 => Granny should invest. RoR = 13.48% 12/22/2015rd25

26. Problem 12-54 Year 012345 ATAX = 10% A-3K1K1K1K1K1K SOYD B-5K1K1.2K1.4K2.6K2.8K ST-LINE n~ABTCFDepTITax 34%ATCF 0 -3K-3K 1 1K1K00 1K 2 1K800200-68 932 3 1K600400-136 864 4 1K400600-204 796 5 1K 200800-272 728 14.39% ATCF-A 0~B-5K-5K 1 1K1K 0 0 1K 2 1.2K1K200-68 1132 3 1.4K1K400-136 1264 4 2.6K1K 1600-544 2056 5 2.8K1K 1800-612 2188 13.68% ATCF-B IRR B-A : (IRR '(-2e3 0 200 400 1260 1460))  12.99% => B > A 12/22/2015rd26

27. Problem 12-57 Buy for $1M or lease for $200K/yr. Annual income is $800K, annual costs are 200K with resale value at $400K. 10-year life with st-line, tax at 40%, ATCF i = 10% nBTCFDepTITax 40%ATCF 0-1M-1M 1-10600K60K540K-216K384K 10 400K -1M(A/P,10%, 10) + 384K + 400K(A/F, 10%, 10) = $246,352.76 BUY LEASE: (800K -200K -200K)0.40 = $160K tax or $240K cash flow EUAB – EUAC = $800K - $200K - $200K -160K = $240K Better to Buy and net $6352.76 12/22/2015rd27

28. 12/22/2015rd28 ATCF Use st-line depreciation with an ATCF of 8% and tax rate of 40% to choose the best system for 6-year lives. A B C First cost $40K$50K$35K UAB 5K 3.5K 10K Salvage 8K 5K 3K Year BTCF St-Line TI Tax 40% ATCF A 1-6 5K 5.333K-0.333 133.33 5133; 8K Salvage B 1-6 3.5K 7.5K-4K 1600 5100; 5K C 1-6 10K 5.333K4666.67 -1866.67 8133; 3K (UIRR 40e3 5133 6 8e3)  -0.75% (UIRR 5e3 -3e3 6 5e3)  -200% A-C (UIRR 50e3 5100 6 10e)  -8.23% (UIRR 5e3 -3033 6 2e3)  -88% B-C (UIRR 35e3 8133 6 3e3)  11.95% C is best

29. ATCF An asset bought for $100K with S = $20K after 5 years is depreciated MACRS 5-year rates. Expense average $18K annually with an effective tax rate of 30%. After 5 years of service the asset is sold for $22K. The ATCF for the sale of the asset is closest to a)$27,760b) $17,130c) $26,870d) $20,585 (dmacrs 100e3 5)  (20000 32000 19200 11520 11520 5760) 22K + 5,760 = $27,760 12/22/2015rd29

30. Taxes on Capital Gains A 3-year property class type equipment bought for $30,000 is sold for $20,000 at the end of three years. The company is at a 34% tax bracket. The tax is a)$5,125.89 b) $7,201.45 c) $6,044.18 d) $7,182.35 (dmacrs 30E3 3)  (9999 13335 4443 2223) Must pay capital gains on (20K – 2223) = $17777 or 0.34 * 17777 = $6044.18 12/22/2015rd30

31. Corporate Taxes Pace Corporation had a taxable income of $300,000 in 2007. Which of the following expression may be used to compute the federal income tax liability for the company? a) 15% of taxable income b) 25% of taxable income c)$113,900 + 34% over $100,000 d)$22,250 + 39% over $100,000 See Tax table Page 395 of text, 12/22/2015rd31

32. Taxes First cost of equipment = $6,000; Salvage value after 5 years = $1,500 MACRS depreciation is used as a 5-year property; Income-tax rate for the company = 34%; Capital gains are taxed at 15% rate. Cash flow is -6000 1600 1600 1600 1600 1600 1600 + 9000 salvage Find ATCF RoR (dmacrs 6E3 5)  (1200 1920 1152 691.2 691.2 345.6) n BTCF Dep TITax RateATCF 0 -6000-$6000 1 1600 1200 400 -136 1464 2 1600 1920 -320 108.8 1708.8 3 1600 1152 448 -152.32 1447.68 4 1600 691.2 908.8 -309 1291.00 5 1600 691.2 908.8 -309 1291.0 6 1600 345.6 1254.4 -426.5 1173.5 6 9000 Capital gain = Market value – Cost basis = 9K - 6K = 3K at 15% Depreciation recapture is cost basis – book value = $6000 – 0 tax @ 34% 12/22/2015rd32

33. 12/22/2015rd33 Income or Profit and Loss Statement Revenue$300,000 Operating Expenses 250,000 Gross Profit 50,000 Administrative Costs 10,000 Other Income 5,000 Net Income Before Tax 45,000 Tax 20,000 Net Income of Net Profit After tax 25,000 Dividends 10,000 Retained Earnings 15,000

34. 12/22/2015rd34 Balance Sheet AssetsLiabilities and Owners Equity Cash $50,000Accounts Payable$30,000 Securities 5,000Note Payable 20,000 Accounts Receivable 5,000Taxes Payable 10,000 Inventory 90,000Common Stock 300,000 Equipment 200,000Retained Earnings 90,000 Buildings 100,000 Total Liability and Total Assets $450,000 Owners Equity $450,000

35. 12/22/2015rd35 AssetsLiabilities Current assetsCurrent liabilities Cash1940 Accounts Payable 1150 Accounts Receivable 950 Notes Payable 80 Securities4100 Inventories1860Accrued expense 950 (-) Bad debt provision -80 Total current liabilities 2180 Fixed assets Long-term liabilities 1200 Land 335 Plant & Equipment6500 (-) Accumulated depr-2350Equity Preferred stock 110 Other assetsCommon stock 650 Prepays/deferred charges 140Capital Surplus 930 Intangibles 420Retained earnings 8745 Total other assets 560 Total equity 10,435 Total assets13,815 Total liabilities and equity 13,815 Balance Sheet Engineered Industries K