1. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 1 Lecture slides to accompany Basics of Engineering Economy by Leland Blank and Anthony Tarquin Chapter 13 After-Tax Analysis

2. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 2 Chapter 13 – After-Tax Analysis PURPOSE Perform an after-tax economic analysis considering income taxes and other tax laws TOPICS Terminology Cash flow after taxes Tax effects of several aspects of depreciation After-tax replacement analysis Weighted average cost of capital (WACC) Spreadsheet usage Economic value-added (EVA) Samples of international tax laws

3. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 3 Sec 13.1 – Terminology and Relations  Gross Income – GI - Total income from all revenue producing function of a corporation, e.g., sales, fees, rent, royalties, contracts  Operating expenses – E - All AOC and M&O corporate costs incurred, e.g., wages and salaries, utilities, materials, rents, subcontracts. These are all income tax deductible  Taxable income – TI – Amount upon which income taxes are based. Expenses and depreciation are deductible TI = GI – E - D

4. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 4 Sec 13.1 – Terminology and Relations  Income taxes – Taxes Annual taxes based on income or profit; levied by governments Corporate and personal taxes are real cash flows and provide governments with large percentages of their revenue  Tax rate – T Percentage (or decimal) of TI owed in taxes Taxes = TI × T Rates are graduated; larger TI’s pay at higher rates  Effective tax rate – T e Single figure tax rate used in economic analyses to approximate graduated rates. Usually between 25% and 50% of TI Taxes = TI × T e To calculate T e, include allowance for state and local (S&L) taxes T e = (S&L rate)+ ( 1 - S&L rate)×(federal rate)

5. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 5 Sec 13.1 – Corporate Tax Rates (2007) Graduated rates mil = $ million

6. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 6 Sec 13.1 – Corporate Taxes – Example 1 Graduated tax rates – T increases from 15% to 39% of TI Indexing – TI ranges are adjusted annually Example: Find income taxes for GI = $2.75 M using graduated tax rates, if E+D = $1.95 M TI = GI – E – D = 2.75 M – 1.95 M = $800,000 Taxes = 50,000(0.15) + 25,000(0.25) + 25,000(0.34) + 235,000(0.39) + (800,000-335,000)(0.34) = $272,000

7. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 7 Sec 13.1 – Corporate Taxes – Example 2 Approximate federal and state income taxes using an effective tax rate, if GI = $5.5 ME+D = $2.8 M Average state rate = 8% Average federal rate = 34% (single-value rate used in lieu of graduated rates) T e = 0.08 + (1 – 0.08)(0.34) = 0.3928 TI = GI – E – D = $2.7 M Taxes = TI × T e = 2.7 M(0.3928) = $1.06 M

8. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 8 Sec 13.1 – Individual Taxes Comparing Corporate and Individual Tax Relations CORPORATE  GI = sales revenue + rents + royalties + etc.  TI = GI – expenses – depreciation  Taxes = TI(T) INDIVIDUAL  GI = salaries + wages + interest + dividends + etc.  TI = GI – personal exemptions – deductibles  Taxes = TI(T)

9. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 9 Sec 13.1 – Individual Tax Rates Annual income taxes are based on filing status: ► Single ► Married and jointly SAMPLE TAX RATE TABLE (2007) Graduated rates TI ranges are adjusted annually

10. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 10 Sec 13.1 – Individual Taxes - Example Salaries = $82,000Dividends = $6,050 4 exemptions @ $3,100/person Deductions = $9,500 Filing status: married and jointly GI = 82,000 + 6,050 = $88,050 TI = 88,050 – 4(3,100) – 9,500 = $66,150 Taxes = 0.10(15,650) + 0.15(63,700-15,650) + 0.25(66,150-63,700) = $9,385 Note: % of year’s GI paid in federal taxes: 9,385/88,050 = 10.7%

11. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 11 Sec 13.2 – CFBT and CFAT Analysis  Replace terms cash flow and net cash flow (NCF) of earlier material with Cash Flow Before Taxes --- CFBT  Introduce new term Cash Flow After Taxes --- CFAT CFAT = CFBT – Taxes = CFBT – TI(T e ) For an economic analysis:  Use effective tax rate T e in lieu of graduated rates  T e includes approximated federal, state and local tax rates

12. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 12 Sec 13.2 – CFBT and CFAT Analysis  CFBT includes First cost P (negative sign) Salvage value S (positive sign) All business expenses E (negative sign) No depreciation deductible CFBT = GI – E – P + S  CFAT includes Depreciation in TI term; not in CFAT directly (negative sign) (Remember: depreciation is not an actual cash flow) Effective tax rate CFAT = CFBT – TI(T e ) = GI – E – P + S – (GI – E – D)(T e )

13. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 13 Sec 13.2 – CFBT and CFAT Analysis Suggested economic analysis column headings CFBT Analysis CFAT Analysis

14. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 14 Sec 13.2 – CFBT and CFAT Analysis In an economic analysis  In some years, TI may be negative (TI < 0), if depreciation exceeds the term GI-E  Consider this a tax savings for the year in the amount of TI(T e )  This approach assumes tax savings are offset by taxes imposed elsewhere in the corporation where TI > 0 Once CFAT series is (are) estimated  Use PW, AW, FW, ROR or B/C method to evaluate one project or multiple alternatives  Selection guidelines are identical to those used previously for a before-tax analysis

15. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 15 Sec 13.2 – CFBT and CFAT Analyses – Example 1 Perform before-tax analyses using ROR method P = $300,000 n = 3 years S = 0 MARR = 15% GI = $200,000 and E = $80,000/year for 4 years Years 1 to 4: CFBT = 200,000 – 80,000 = $120,000 PW = -300,000 + 120,000(P/A,i%,4) i = 21.86% > 15% Project justified

16. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 16 Sec 13.2 – CFBT and CFAT Analyses – Example 2 Perform after-tax ROR analyses at after-tax MARR = 9.75% P = $300,000 S = 0 n = 3 years T e = 0.35 Depreciation method:3-year MACRS GI = $200,000 and E = $80,000/year for 4 years Years 1 to 4: CFAT = GI – E – (GI – E – D)(T e ) = 200,000 – 80,000 - (120,000 – MACRS D t )(0.35) cont →

17. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 17 Sec 13.2 – CFBT and CFAT Analyses – Example 2 G - E - taxes = 120,000 - taxes Tax savings PW = -300,000 + 112,997(P/F,i%,1) +···+ 85,781(P/F,i%,4) i = 15.54% > 9.75% Project still justified

18. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 18 Sec 13.2 – CFAT Evaluation of Multiple Alternatives PW method: Use LCM of lives for different life alternatives ROR method: Perform incremental analysis of CFAT series B/C method: Perform incremental analysis of CFAT series AW method: Preferred method, since LCM or incremental analysis is not necessary Note: Use spreadsheets when possible See Sec 13.6 for examples

19. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 19 Sec 13.2 – After-tax and Before-tax ROR To estimate after-tax ROR, without performing details of after-tax analysis, an approximate answer is obtained by using After-tax ROR = Before-tax ROR(1 – T e ) Similar logic holds for MARR when PW or AW analysis is performed After-tax MARR = Before-tax MARR(1 – T e )  In previous example, before-tax MARR = 15% and T e = 35% After-tax MARR = 15%(1- 0.35) = 9.75%

20. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 20 Sec 13.3 – Depreciation Effect on Taxes Some aspects of depreciation and tax law alter income tax amounts and patterns:  Depreciation recapture (DR)  Depreciation method  Recovery period  Capital gain  Capital loss Depreciation recapture – Occurs at time of sale when asset is sold for more than book value For after-tax analysis considering DR, it is important to have a good sense of the estimated selling price SP (also called salvage value) DR = selling price – book value

21. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 21 Sec 13.3 – Depreciation Recapture oIn the year an asset is sold DR = SP – BV oDR is present when asset is disposed of at end of its life and MACRS was applied  MACRS always depreciates to zero (S = 0) in year n +1 oDR is taxed as ordinary TI at effective rate of T e oIf asset selling price > first cost, there is DR plus a capital gain (CG)

22. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 22 Sec 13.3 – Capital Gains and Losses Capital Gain (CG)  Difficult to predict; usually neglected in economic study, except …  when asset appreciates, such as building or land  Taxed as ordinary TI at effective rate T e  If P is first cost or initial depreciation basis CG = selling price – first cost = SP – P Capital Loss (CL)  Difficult to predict; usually neglected in economic study, except …  in an after-tax replacement study, if defender is traded at ‘sacrifice’ value  For taxes, CL can only offset CG of other activities  CL occurs when asset is sold for less than book value CL = book value - selling price = BV - SP

23. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 23 Sec 13.3 – Tax Treatment Summary  Updated taxable income relation is now TI = GI – E – D + DR + CG - CL

24. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 24 Sec 13.3 – Effect on Taxes - Example GI = $100,000T e = 35%3-year contract After 3 years, expected selling prices are: SP 1 = $130,000 SP 2 = $225,000  When sold after 3 years, there will be depreciation recapture since SP > BV (see table on next slide) DR 1 = 130,000 – 43,200 = $86,800 DR 2 = 225,000 – 64,800 = $160,200 Taxed at T e = 35% cont →

25. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 25 Sec 13.3 – Effect on Taxes - Example 128,000 44,800 $66,500 207,000 72,450 $94,500 TI = 100,000 – 30,000 – 28,800 + 86,800 = $128,000 TI = 100,000 – 30,000 – 43,200 + 160,200 = $207,000 Analyzer 1 has tax advantage

26. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 26 Sec 13.3 – Depreciation Effect on Taxes Consider depreciation method and recovery period When compared to straight line (SL) depreciation rates, taxes are affected by –Accelerated depreciation rates –Shortened recovery periods Larger rates in earlier years (like DDB and MACRS rates) require less taxes in these years Smaller n values provide larger deductible amounts when determining TI Goal: minimize PW tax value over n years t = n PW tax = Σ (taxes for year t)(P/F,i%,t) t = 1

27. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 27 Sec 13.3 – Depreciation Effect on Taxes Assumptions to minimize PW tax for accelerated rates and shortened recovery periods 1.Constant, single-value tax rate applies 2.CFBT exceeds annual depreciation amount 3.Depreciation method writes-off to same salvage value Following are then correct: Total taxes paid are equal for all rate and n value patterns PW tax is less for accelerated rates with same n value PW tax is less for smaller n values with same depreciation method This is important to remember

28. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 28 Sec 13.4 – After-Tax Replacement Study ► Considers DR or CG, if challenger selected ► Can include CL, if trade occurs at very low (‘sacrifice’) trade-in for defender ► May reverse final alternative decision compared to before-tax analysis, but more likely, it … ► Provides idea of the difference in PW or AW value at specific after-tax MARR when taxes are included ► Apply same procedure as before-tax evaluation once CFAT series is estimated

29. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 29 Sec 13.4 – After-Tax Replacement - Example 3 years ago defender purchased for $600,000 with n = 8 Effective tax rate is 34% Study period is 5 years Straight line depreciation: D t = $75,000/year for 8 years After-tax MARR = 7% Assume GI is same for defender and challenger Question: retain defender D or select challenger C? cont →

30. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 30 Sec 13.4 – After-Tax Replacement - Example DEFENDER ANALYSIS First cost: P D = $-400,000, current trade-in value Taxes: no DR occurs if not traded for challenger Taxes = (E-D)T e = (-100,000 - 75,000)(0.34) = $-59,500 CFAT = CFBT – Taxes = -100,000 - (-59,500) = $-40,500 AW D = - 400,000(A/P,7%,5) - 40,500 = $-138,056 cont →

31. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 31 Sec 13.4 – After-Tax Replacement - Example CHALLENGER ANALYSIS Taxes: DR occurs when defender is traded; $400,000 > BV 3 Defender BV 3 = 600,000 – 3(75,000) = $375,000 DR = SP – BV = 400,000 – 375,000 = $25,000 Extra taxes on trade-in in year 0: 25,000(0.34) = $8,500 Challenger depreciation: 1,000,000/5 = $200,000 Taxes, years 1-5: Tax savings = (E-D)T e = (-15,000 - 200,000)(0.34) = $-73,100 Annual CFAT is positive: CFAT = CFBT – Taxes = -15,000 - (-73,100) = $+58,100 cont →

32. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 32 Sec 13.4 – After-Tax Replacement - Example AW C = - 1,008,500(A/P,7%,5) + 58,100 = $-187,863 From defender analysis: AW D = $-138,056 Conclusion: Retain defender

33. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 33 Sec 13.5 – Capital and Cost of Capital  Capital – Funds used to finance engineering and other projects  Cost of capital – Interest rate paid for capital funds  MARR - Interest rate used in economic analysis. It is always set to exceed cost of capital To set MARR, understand the types of capital and how to calculate cost of capital TYPES OF CAPITAL Debt capital – Funds borrowed from outside the corporation and its owners/stockholders Equity capital – Funds retained in corporation for future use and funds obtained from owners of the corporation

34. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 34 Sec 13.5 – Debt and Equity Capital  Debt capital – Includes loans, notes, mortgages, and bonds Debt is repaid at a specified interest rate on a set schedule  Equity capital – Includes o Retained earnings o Individual owners’ funds o Sales of stock to public investors Debt-to-equity (D-E) mix – ratio of debt to equity capital for the corporation or a particular project Example: $55 M in capital funds are sourced from retained earnings ($33 M) and borrowed via bonds ($22 M) Debt: $22 M/55 M = 40% Equity: $33 M/55 M = 60% D-E mix is 40%/60%

35. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 35 Sec 13.5 – Cost of Capital Weighted Average Cost of Capital (WACC) Use D-E mix with cost of debt and equity capital to estimate WACC WACC definition: Estimate of interest rate (in percentage) for all funds in the capital pool that finances projects to be economically evaluated WACC is a weighted average WACC = (equity fraction)×(cost of equity capital) + (debt fraction)×(cost of debt capital) MARR is set to exceed WACC by the desired rate of return

36. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 36 Sec 13.5 – Cost of Capital Curves General shape of WACC curve WACC at 100% debt capital WACC at 100% equity capital Most firms operate within a range of D-E mixes

37. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 37 Sec 13.5 – Cost of Capital - Example  Project funded at $10 M as follows:  Equity: stock sales of $5 M at interest rate 13.7%/year  Equity: retained earnings of $2 M at interest rate 8.9%/year  Debt: bond sales of $3 M at interest rate 7.5%/year  Find MARR, if return of 5%/year is required Approach: Find WACC by separating two equity sources in WACC relation, then add 5% to determine MARR WACC = stock rate + retained earnings rate + bond rate = 0.5(13.7%) + 0.2(8.9%) + 0.3(7.5%) = 10.88% MARR = WACC + 5% = 15.88%/year

38. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 38 Sec 13.5 – Debt and Equity Capital Debt capital advantages:  Don’t use corporation’s own funds  Offers tax deductibility for interest paid on debts Debt capital disadvantages:  Large D-E mixes are risky for a corporation  Corporation owns less and less of itself  Makes it harder to borrow more funds  Inability to obtain additional funding makes new project financing difficult; competition gains market advantages D-E mixes in the 50-50 range are called highly leveraged

39. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 39 Sec 13.5 – D-E Mix – Example 1 Varying D-E mixes for 3 corporations; Compare returns on equity funds A: Net income = $14.4 MReturn = 14.4/40 = 36% B: Net income = $13.4 MReturn = 13.4/20 = 67% C: Net income = $10.0 MReturn = 10.0/10 = 100% Great return on equity capital for B and C compared to A, but… owner’s own only 20% of C; risk is much higher for company C

40. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 40 Sec 13.5 – D-E Mix – Example 2 ◄ Same leverage problems exist for individuals as for corporations ◄ Persons with large debts (house, car, credit cards, appliances, luxury items, vacations, etc.) are at risk and find it harder to acquire additional credit Example: Assume two engineers have ◄Same $60,000 net income after all taxes, etc. ◄Same cost of debt that averages 15% per year ◄Same repayment of debt principal -- equal payments over 20 years Jamal has $25,000 debt; Barry has $150,000 debt cont →

41. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 41 Sec 13.5 – D-E Mix – Example 2 Barry has much less of his $60,000 net income left; only $30,000 or 50%, compared to $55,000 for Jamal Barry is paying much more in interest; $22,500 this year compared to only $3,750 for Jamal Barry is at more risk than Jamal, and Barry probably has a poorer credit rating

42. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 42 Sec 13.5 – Debt and Equity Capital After-tax analyses should consider debt capital, because the interest paid on debts is tax deductible for corporations (in the US, at least) Equity capital does not have this tax advantage; stock dividends, etc. are not tax deductible If a detailed after-tax evaluation is not made, approximate after-tax rates can be estimated using: After-tax cost of debt capital = (before-tax cost)×(1-T e ) After-tax WACC = (equity fraction)×(cost of equity) + (debt fraction)×(after-tax cost of debt) After-tax MARR = after-tax WACC + required return

43. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 43 Sec 13.6 – Spreadsheet Usage Spreadsheets illustrate 4 different ways to evaluate the same two alternatives Effective tax rate is 35%; both assets sold after 3 years Conclusion: Using an after-tax MARR of 10%, alternative 2 is correctly selected by all methods cont →

44. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 44 Sec 13.6 – Spreadsheet Usage Spreadsheet solution includes  MACRS depreciation over 5 years  Income taxes at 35% effective rate  Salvage (selling price)  Depreciation recapture at sale after 3 years, because SP > BV  No capital gains or losses Equation used in spreadsheet for CFAT is: CFAT = CFBT – taxes = GI – E – P + S – (GI – E – D + DR)(T e ) cont →

45. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 45 Sec 13.6 – Spreadsheet Usage PW and AW evaluation over 3-year study period cont → PW 2 and AW 2 larger; select Analyzer 2

46. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 46 Sec 13.6 – Spreadsheet Usage Incremental ROR evaluation – column J added cont → ∆i* > 10%; select Analyzer 2

47. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 47 Sec 13.6 – Spreadsheet Usage Graphical analysis using breakeven ROR Breakeven ROR >10%; select Analyzer 2

48. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 48 Sec 13.7 – Value-Added Analysis  Value added – Added economic worth from the consumer’s, owner’s or investor’s perspective Example: The average consumer is willing to pay significantly more for potatoes processed and served at a fast-food restaurant as fries (chips) than as raw potatoes in the skin from a supermarket  Value-added analysis is performed in a different way than CFAT analysis  Selection of the better economic alternative is the same for economic value added (EVA) analysis and CFAT analysis, because … AW of EVA estimates = AW and CFAT estimate

49. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 49 Sec 13.7 – Value-Added Analysis How economic value-added (EVA) analysis works  Determine NPAT – Net Profit After Taxes: What remains after taxes are subtracted from taxable income  NPAT = TI – taxes = TI – TI(T e ) = TI×(1 – T e )  NPAT implicitly includes depreciation through TI; different from CFAT which explicitly considers only actual cash flows  Calculation: EVA is NPAT minus cost of invested capital, i.e., required interest on book value (remaining capital investment) is removed from NPAT to form EVA  Definition: EVA is contribution of investment to net worth of a corporation after taxes

50. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 50 Sec 13.7 – Value-Added Analysis Each year determine the following: EVA = NPAT – cost of invested capital = NPAT – (after-tax MARR)(BV t-1 ) = TI×(1 – T e ) - i×(BV t-1 ) EVA is a measure of financial worth that mingles actual cash flows and noncash flows EVA estimates extra worth that an alternative adds to the corporation CFAT estimates (describes) how actual cash will flow Alternative selection: Determine AW of EVA series; select alternative with the better AW value AW of EVA series will always = AW of CFAT series

51. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 51 Sec 13.7 – EVA Analysis - Example After-tax MARR = 12%SL depreciation T e = 40% For EVA calculation each year t: NPAT t = TI×(1 – T e ) = (170,000 – 125,000)(0.6) = $27,000 EVA t = NPAT t - i×(BV t-1 ) = 27,000 – 0.12(BV t-1 ) EVA and CFAT evaluation of a project cont →

52. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 52 Sec 13.7 – EVA Analysis - Example cont →

53. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 53 Sec 13.7 – EVA Analysis - Example Observations about EVA and CFAT analysis EVA  There is no EVA in year t = 0, since NPAT and cost of invested capital is present only for years 1 to n  AW of EVA < 0 means project is not justified at 12%  Project does not add value to the corporation until year 3 when EVA turns positive CFAT  AW of CFAT < 0 means project is not justified at 12%  CFAT estimates actual cash flow, which is negative in year 0 and positive thereafter CONCLUSIONS  AW values of EVA and CFAT series are exactly equal  Two methods are economically equivalent

54. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 54 Sec 13.8 – Taxes for International Projects Tax related questions for internationally located projects concentrate on items such as  Depreciation methods approved  Business expense deductibility  Tax rates  Indirect tax rates - Value Added Tax and General Service Tax (VAT/GST)  Capital investment allowances Rules and laws vary considerably from country to country Examples for Canada, Mexico and Japan are summarized

55. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 55 Sec 13.8 – Taxes for International Projects CANADA  Depreciation – DB or SL method  Equivalent of half-year convention in first year  Annual depreciation allowance is called Capital Cost Allowance (CCA)  Standard recovery rates are tabulated  Asset classes define recovery periods  Business expenses are deductible in calculating TI

56. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 56 Sec 13.8 – Taxes for International Projects MEXICO  Depreciation - SL method with inflation index  Recovery rates - Common range is 10% to 30% per year. Some recovery rates vary from 5%/year (buildings) to 100% (environmental machinery)  Income tax is levied on profit on income earned in Mexico  Tax on Net Assets (TNA) of 1.8% of the average value of assets located in Mexico  Business expenses are deductible in calculating TI

57. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 57 Sec 13.8 – Taxes for International Projects JAPAN  Depreciation – SL or DB methods with 95% of first cost recoverable. Salvage of 10% is always assumed  Class and life – 4 to 24 years; up to 50 years for structures  Business expenses are deductible in calculating TI International income tax and indirect tax rates (VAT/GST) are summarized annually in a publication available at www.kpmg.com entitledwww.kpmg.com KPMG’s Corporate and Indirect Tax Rate Survey

58. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 58 Sec 13.8 – Tax Rates for Selected Countries

59. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 59 Sec 13.8 – Taxes for International Projects International Corporate Tax Rates - ‘97-‘07 Source: KPMG’s Corporate and Indirect Tax Rate Survey 2007, p. 10 World average for 2000: 32.0% World average for 2007: 26.8% Rate of decreasing tax rates is slowing

60. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 60 Sec 13.8 – Taxes for International Projects OECD range: 5 to 25% World average: 15.6% In US: No VAT, however 45 states impose Sales and Use Taxes on foreign corporations 2007 VAT/GST Rates for OECD Nations

61. Slide to accompany Blank and Tarquin Basics of Engineering Economy, 2008 © 2008, McGraw-Hill All rights reserved 13 - 61 Sec 13.8 – Taxes for International Projects International tax rates have been dropping for some years -- this encourages inward investing Indirect tax rates (VAT/GST) are increasing to recover revenue shortfalls from reduced income taxes