Lectures in Engineering Economy Prof. Corrado lo Storto DIEG, Dept. of Economics and Engineering Management School of Engineering, University of Naples Federico II email: corrado.lostorto@unina.it phone: 081-768.2932

Major issues Income tax definition (individual and corporate) Tax and net income Before-tax and after-tax analysis How to develop the format of after-tax cash flow statement? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Income taxes Since taxes are a cash outflow of a project, economic analyses should reflect the after-tax cash flow of a project in order to achieve a true reflection of the cash flow patterns. Tax laws are imposed for revenue generation. However, a secondary purpose is that of social legislation. The laws are very complex with many exceptions. However, this lecture will focus on the fundamental concepts. In a sense, the government shares in every profitable venture through the taxation of a portion of the profits. The contrary is also true if the individual or corporation has other profit generating activities to offset the loss in a venture. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Forms of business organization for tax purposes Individual: Applicable to an employee, a sole proprietor (individual engaging in business alone) or individual members of partnerships; taxed at individual rates; Partnership: Must file annual information return, each partner is taxed on his share of partnership earnings - whether or not distributed; Corporation: Taxed at corporate tax rates unless the corporation is treated like a partnership. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Forms of business organization for tax purposes Earnings to a corporation are taxed twice: Once while in the corporation Once after distribution to shareholders as dividends This occurs because dividends are usually not a tax deductible expense for the corporation. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Taxation for individuals Marginal percentage rates increase as taxable income increases. Taxable income = adjusted gross income (revenue, earnings) - deductions for exemptions - itemized deductions in excess of standard deduction Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Taxation for corporations Tax rates: approx. 35% currently (depends on Country) Lower rates for taxable income below $10,000,000 (approx., depends on Country) Taxable income = gross income (revenue) - expenditures for operating expenses - tax depreciation and depletion Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Taxation for corporations A key point to remember is that capital expenditures (buildings, machinery, etc.) are not deductible as operating expenses, but rather are recovered through depreciation or depletion. A second key point to note is that depreciation when considered as a tax deduction results in less taxes and therefore is a source of cash flow to match the cash outflow when the investment is made. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example of computation of taxable income and computation of income tax for a corporation Gross Income (or revenue) $ 3,000,000 - Salaries $ 180,000 - Operating Costs $ 200,000 - Raw Materials $ 1,500,000 - Tax Depreciation $ 620,000 Taxable Income $ 500,000 Taxes Payable @ 35% $ 175,000 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example of computation of taxable income and computation of income tax for a corporation As a practical matter, we normally assume a corporate tax rate of 35% ignoring the smaller rates at lower levels of taxable income. We do this because usually the firm for which the analysis is being done is large enough to have many projects and since the lower rates may be used on only once, the marginal rate for most corporations is 35%. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Capital gains and losses If the selling price of a capital asset exceeds the book value, the excess of selling price over book value is called a capital gain. If the selling price is less than book value, the difference is a capital loss. For a corporation, capital gains are taxed at ordinary corporate tax rates. Corporate capital losses can be subtracted from any capital gains during the tax year. The net remaining losses may be carried back or forward. In general, capital losses cannot be used to offset ordinary operating income. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Key Accounting Concepts Financial Accounting (Or Book) Net Income - earnings after recognition of revenues less operating expenses, book depreciation, and the book tax provision. Revenues - value of product sales or services rendered. Operating Expenses - salaries, product materials, rent, etc. Capital expenditures and dividends are not operating expenses. Book Depreciation - systematic allocation of original cost over the useful life of the asset. Book Tax Provision - tax rate times income before taxes. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Tax Accounting Net Income - no such term in tax accounting. Revenues - generally similar to book revenues. We assume no difference. Operating Expenses - generally similar to book definition. We assume no difference. Book Depreciation - no such term in tax accounting. Tax Depreciation – i.e., MACRS allocation of tax basis in US. Tax Basis - historical cost of asset less any accumulated tax depreciation. Taxable Income - revenues less operating expenses less tax depreciation. Current Taxes Payable - taxable income times tax rate. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

The Concept of Deferred Taxes Deferred income taxes is a concept associated only with the book or financial accounting. It is not a tax accounting concept. Tax accounting computes an income tax payable. It is payable for and within the current year. Book accounting also computes a provision for income taxes as a reduction of net income. Thus, the book provision for income taxes is based upon book depreciation and will differ from current taxes payable if book and tax depreciation are not equal. The difference between current taxes payable and the book tax provision is known as deferred taxes and thus is important in tracking cash. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Comparison between tax and book account Tax Book Revenues $10,000 $10,000 Operating Expenses 2,000 2,000 8,000 8,000 Depreciation 4,000 2,000 Taxable Income 4,000 - Income Before Taxes 6,000 Current Taxes Payable (35%) $ 1,400 Book Provision (35%) 2,100 Net Income $ 3,900 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Tax and book account, and the deferred tax Thus, our book provision for income taxes is $2,100 while our current taxes are $1,400. The difference of $700 is known as a deferred tax. The meaning of a deferred tax is that it represents a tax on current book year earnings that will be paid in a future year. The deferred tax could alternatively be computed as the difference in tax and book depreciation (4,000-2,000) times the tax rate (35%). Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Tax and book account, and the deferred tax Assume the following depreciation schedules for book and tax purposes for a $10,000 asset: Tax Book Tax Deferred Accumulated Year Depreciation Depreciation Difference Rate Tax Deferred Tax 1 800 1,000 (200) 35% (70) (70) 2 1,400 1,000 400 35% 140 70 3 1,200 1,000 200 35% 70 140 4 1,000 1,000 - 35% - 140 5 1,000 1,000 - 35% - 140 6 1,000 1,000 - 35% - 140 7 900 1,000 (100) 35% (35) 115 8 900 1,000 (100) 35% (35) 70 9 900 1,000 (100) 35% (35) 35 10 900 1,000 (100) 35% (35) -0- 10,000 10,000 -0- -0- Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Tax depreciation trend 200 400 600 800 1000 1200 1400 1 2 3 4 5 6 7 8 9 10 year Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

The deferred tax: Key Points 1. The deferred tax in the first year is negative meaning that the current taxes payable to the government are higher than the book income tax provision. 2. Over time the exact same amount will be taken for tax depreciation as taken for book depreciation. 3. Since the statement in 2. is correct, it follows that over time the accumulated deferred tax will become zero. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Taxable Income and Income Taxes Item Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Corporate Income Taxes Facts: Capital expenditure $ 100,000 (allowed depreciation) $ 58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold $ 840,000 Depreciation $ 58,000 Leasing warehouse $ 20,000 Question: Taxable income? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Corporate Income Taxes Taxable income: Gross income $1,250,000 - Expenses: (cost of goods sold) $840,000 (depreciation) $58,000 (leasing expense) $20,000 Taxable income $332,000 Income taxes: First $50,000 @ 15% $ 7,500 $25,000 @ 25% $ 6,250 $25,000 @ 34% $ 8,500 $232,000 @ 39% $ 90,480 Total taxes $ 112,730 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Corporate Income Taxes Average tax rate: Total taxes = $112,730 Taxable income = $332,000 Marginal tax rate: Tax rate that is applied to the last dollar earned 39% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Net Income Calculation Item Amount Gross income (revenue) $50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6,000 Taxable income Taxes (40%) 8,000 Net income $12,000 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example of corporate taxation: the U.S. Corporate Tax Rate (2005) Tax rates are progressive: the more you earn, the more you pay Tax rates increase in stair-step fashion Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 35% 38% Tax computation $0 + 0.15(D) $7,500 + 0.25 (D) $13,750 + 0.34(D) $22,250 + 0.39 (D) $113,900 + 0.34 (D) $3,400,000 + 0.35 (D) $5,150,000 + 0.38 (D) $6,416,666 + 0.35 (D) (D) denotes the taxable income in excess of the lower bound of each tax bracket Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Capital Expenditure versus Depreciation Expenses 1 2 3 4 5 6 7 8 Capital expenditure (actual cash flow) $28,000 1 2 3 4 7 6 7 8 $1,250 $3,500 $2,500 $2,500 $2,500 $4,000 $4,900 $6,850 Allowed depreciation expenses (not cash flow) (tax depreciation according to US MACRS) Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Cash Flow vs. Net Income Net income: Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow: Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, cash flows are more relevant data to use in project evaluation. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Why Do We Use Cash Flow in Project Evaluation? Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period. Company A Company B Year 1 Net income Cash flow $1,000,000 1,000,000 Year 2 2,000,000 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Cash Flow versus Net Income Item Income Cash Flow Gross income (revenue $50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6,000 -20,000 -6,000 Taxable income Taxes (40%) 8,000 -8,000 Net income $12,000 Net cash flow $16,000 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Net income versus net cash flow Net cash flows = Net income + non-cash expense (depreciation) $50,000 Net income Net cash flow $12,000 $40,000 Depreciation $4,000 Income taxes $8,000 $30,000 Gross revenue $6,000 Operating expenses $20,000 $10,000 $20,000 Cost of goods sold $0 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Just to remember… Revenues - Operating Expenses - Depreciation (Book) = Income Before Taxes - Book Tax Provision = Net Income Key Comment: Net income does not equate to cash flow from operations as discussed later. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Just to remember… Revenues - Operating Expenses - Tax Depreciation = Taxable Income x Tax Rate = Current Taxes Payable Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

After-Tax Economic Analyses After-tax economic analyses (ATCFs) can be performed by using exctly the same methods as before-tax analyses. The only difference is that ATCFs are used in place of before-tax cash flows (BTCFs) by including expenses (or savings) due to income taxes and then making equivalent worth calculations using an after-tax MARR. The income tax rates and governing regulations may be complex and subject to changes, but once those rates and regulations have been translated into their effect on ATCFs, the remainder of the after-tax analysis is relatively straigthforward Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

After-Tax Economic Analyses To formalize the procedure, the following notation is adopted: Rk= revenues from the project; this is the positive cash flow from the project during period k, Ek= cash outflows during year k for deductible expenses and interest, dk= sum of all noncash, or book, costs during year k, such as depreciation and depletion, t= effective income tax rate on ordinary income; t is assumed to remain constant during the study period, Tk= income taxes paid during year k ATCFk=ATCF from the project during year k K=0, 1, 2, …, N Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

After-Tax Economic Analyses Because net income before-tax (NIBT) is Rk – Ek - dk The ordinary income tax liability when Rk>(Ek-dk) is computed as Tk=-t(Rk-Ek-dk) The net income after-tax (NIAT) is then simply taxable income (i.e., net income before tax) minus the tax liability amount detemined NIATk=(Rk-Ek-dk)-t(Rk-Ek-dk) or NIATk=(Rk-Ek-dk)(1-t) The ATCF associated with a project equals the NIAT plus noncash items such as depreciation ATCFk=NIATk+dk=(Rk-Ek-dk)(1-t)+dk=(Rk-Ek)(1-t)+tdk Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

After-Tax Economic Analyses In many economic analyses of engineering and business projects, ATCFs in year k are computed in terms of BTCFs (i.e., year k before-tax cash flows) BTCFk=Rk-Ek Thus, ATCFk=BTCFk+Tk =(Rk-Ek)-t(Rk-Ek-dk) =(1-t)(Rk-Ek)+tdk Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

After-Tax Economic Analyses A Table useful to facilitate the computation of after-tax cash flows year (A) Before-tax Cash flow (B) Depreciation (C )=(A)-(B) Taxable income (D)=-t(C ) Cash flow for income taxes (E)=(A)+(D)After-tax cash flow k Rk-Ek dk Rk-Ek-dk -t(Rk-Ek-dk) (1-t)(Rk-Ek)+tdk Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Project Cash Flow Analysis How to develop the format of after-tax cash flow statement? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Types of Cash Flow Elements in Project Analysis Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Cash Flows from Operating Activities Approach 1 Income Statement Approach Approach 2 Direct Cash Flow Approach Operating revenues - Cost of goods sold - Depreciation - Operating expenses - Interest expenses Taxable income - Income taxes Net income + Depreciation Cash flow from operation Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

A Typical Format used for Presenting Cash Flow Statement + Net income +Depreciation Capital investment + Proceeds from sales of depreciable assets Gains tax Investments in working capital + Working capital recovery + Borrowed funds Repayment of principal Net cash flow Operating activities Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income + Investing activities + Financing activities Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: The Automated Machining Center Project (when projects require only operating and investing activities) Project Nature: Installation of a new computer control system Financial Data: Investment: $125,000 Project life: 5 years Working capital investment: $23,331 Salvage value: $50,000 Annual labor savings: $100,000 Annual additional expenses: Labor: $20,000 Material: $12,000 Overhead: $8,000 Depreciation Method: 7-year MACRS Income tax rate: 40% MARR: 15% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: The Automated Machining Center Project (when projects require working capital investments) Working capital means the amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs. How to treat working capital investments: just like a capital expenditure except that no depreciation is allowed. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Questions Develop the project’s cash flows over its project life. Is this project justifiable at a MARR of 15%? What is the internal rate of return of this project? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

(a) Step 1: Depreciation Calculation Cost Base = $125,000 Recovery Period = 7-year MACRS N MACRS Rate Depreciation Amount Allowed Depreciation Amount 1 14.29% $17,863 2 24.49% $30,613 3 17.49% $21,863 4 12.49% $15,613 5 8.93% $11,150 $5,575 6 8.92% 7 8 4.46% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

(a) Step 2: Gains (Losses) associated with Asset Disposal Salvage value = $50,000 Book Value (year 5) = Cost Base – Total Depreciation = $125,000 - $ 91,525 = $ 33,475 Taxable gains = Salvage Value – Book Value = $50,000 - $ 33,475 = $16,525 Gains taxes = (Taxable Gains)(Tax Rate) = $16,525 (0.40) = $6,610 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Step 3 – Create an Income Statement 1 2 3 4 5 Revenues $100,000 Expenses: Labor 20,000 Material 12,000 Overhead 8,000 Depreciation 17,863 30,613 21,863 15,613 5,581 Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419 Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768 Net Income $25,282 $17,632 $22,882 $26,632 $32,651 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Step 4 – Develop a Cash Flow Statement 1 2 3 4 5 Operating Activities: Net Income $25,282 $17,632 $22,882 $26,632 $32,651 Depreciation $17,863 $30,613 $21,863 $15,613 $5,581 Investment Activities: Investment ($125,000) Working capital ($23,331) $23,331 Salvage $50,000 Gains Tax ($6,613) Net Cash Flow ($148,331) $43,145 $48,245 $44,745 $42,245 $104,950 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

An Excel Worksheet Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Investment & Salvage Value Example: Net Cash Flow Table Generated by Traditional Method Using Approach 2 A B C D E F G H I J Year End Investment & Salvage Value Revenue Labor Expenses Materials Overhead Depreciation Taxable Income Income Taxes Net Cash Flow -$125,000 -$23,331 1 $100,000 $20,000 $12,000 $8,000 $17,863 $42,137 $16,855 $43,145 2 $30,613 $29,387 $11,755 $48,245 3 $21,863 $38,137 $15,255 $44,745 4 $15,613 $44,387 $17,755 $42,245 5 $5,581 $54,419 $21,678 $38,232 $50,000* 23,331 $16,525 $6,613 $43,387 $23,331 *Salvage value Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I Information required to calculate the income taxes Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Cash Flow Diagram including Working Capital $23,331 Working capital recovery $44,745 $81,619 $48,245 $43,145 $42,245 1 2 3 4 5 $125,000 Investment in physical assets $23,331 $23,331 $23,331 Investment in working capital 1 2 3 4 5 Years $23,331 $23,331 Working capital recovery cycles Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Question (b): Is this investment justifiable at a MARR of 15%? PW(15%) = -$148,331 + +$43,145(P/F, 15%, 1) + . . . . + $104,950 (P/F, 15%, 5) = $31,420 > 0 Yes, Accept the Project ! $104,950 $48,245 $44,745 $42,245 $43,145 1 2 3 4 5 Years $148,331 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Question (C): IRR A B 1 Period Cash Flow 2 ($148,331) 3 $43,145 4 ($148,331) 3 $43,145 4 $48,245 5 $44,745 6 $42,245 7 $104,950 =IRR(B2:B7,0.10) IRR = 22.55% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Rate of Return Analysis (IRR = 22.55%) Beginning Balance -$148,331 -$138,635 -$121,652 -$104,339 -$85,622 Return on Investment (interest) -$33,449 -$31,262 -$27,432 -$23,528 -$19,328 Payment $43,145 $48,245 $44,745 $42,245 $104,950 Project Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

When Projects are Financed with Borrowed Funds Key issue: Interest payment is a tax-deductible expense. What Needs to Be Done: Once a loan repayment schedule is known, separate the interest payments from the annual installments. What about Principal Payments? As the amount of borrowing is NOT viewed as income to the borrower, the repayments of principal are NOT viewed as expenses either– NO tax effect. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Loan Repayment Schedule (Example) Amount financed: $62,500, or 50% of total capital expenditure Financing rate: 10% per year Annual installment: $16,487 or, A = $62,500(A/P, 10%, 5) End of Year Beginning Balance Interest Payment Principal Payment Ending 1 $62,500 $6,250 $10,237 $52,263 2 $5,226 $11,261 $41,002 3 $4,100 $12,387 $28,615 4 $2,861 $13,626 $14,989 5 $1,499 $14,988 $16,487 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Loan Repayment Schedule (Example) Additional entries related to debt financing Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

When Projects Results in Negative Taxable Income Negative taxable income (project loss) means you can reduce your taxable income from regular business operation by the amount of loss, which results in a tax savings. Handling Project Loss Regular Business Project Combined Operation Taxable income Income taxes (35%) $100M $35M (10M) ? $90M $31.5M Tax savings Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Item Effects of Inflation Depreciation expense Depreciation expense is charged to taxable income in money of declining values; taxable income is overstated, resulting in higher taxes Note: Depreciation expenses are based on historical costs and always expressed in actual money Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Item Effects of Inflation Salvage value Inflated salvage value combined with book values based on historical costs results in higher taxable gains. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Item Effects of Inflation Loan repayments Borrowers repay historical loan amounts with money of decreased purchasing power, reducing the debt-financing cost. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Item Effects of Inflation Working capital requirement Known as working capital drain, the cost of working capital increases in an inflationary environment. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Item Effects of Inflation Rate of Return and NPW Unless revenues are sufficiently increased to keep pace with inflation, tax effects and/or a working capital drain result in lower rate of return or lower NPW. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Effects of Inflation on Project Cash Flows Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example: Applying Specific Inflation Rates Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Rate of Return Analysis under Inflation Principle:True (real) rate of return should be based on constant money. If the rate of return is computed based on actual money, the real rate of return can be calculated as: n Net cash flows in actual dollars Net cash flows in constant dollars 1 2 3 4 -$30,000 $13,570 $15,860 $13,358 $13,626 $12,336 $13,108 $10,036 $9,307 IRR 31.34% 19.40% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Decision Criterion If you use 31.34% as your IRR, you should use a market interest rate (or inflation-adjusted MARR) to make an accept and reject decision. If you use 19.40% as your IRR, you should use an inflation-free interest rate (inflation-free MARR) to make an accept and reject decision. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Example Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Calculating the after-tax Cost of Debt Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Practice Problem Alpha Corporation needs to raise $10 million and has decided to finance $4 million by securing a term loan and issuing 20‑year $1,000 par bonds for the following condition. (The remaining funds would be raised through equity financing.) Alpha’s marginal tax rate is 38%, and it is expected to remain constant in the future. What is the after-tax cost of debt? Source Amount Fraction Interest rate Term Loan Bond $1.33M $2.67M 0.333 0.667 12% 10.74% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Summary Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation. The four components of information required to calculate depreciation are: (a) cost basis, (b) salvage value, (c) depreciable life , and (4) depreciation method. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Summary Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation. The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted. It only changes the timing of the payment. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

Summary Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project. Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto