1. Lectures in Engineering Economy
Prof. Corrado lo Storto
DIEG, Dept. of Economics and Engineering Management
School of Engineering, University of Naples Federico II
phone:

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

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

10. 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

11. 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

12. 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

13. 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

14. 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

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

16. 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

17. 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
,000 (200) 35% (70) (70)
2 1,400 1, %
3 1,200 1, %
4 1,000 1, % - 140
5 1,000 1, % - 140
6 1,000 1, % - 140
,000 (100) 35% (35) 115
,000 (100) 35% (35) 70
,000 (100) 35% (35) 35
,000 (100) 35% (35) -0-
10,000 10,
Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

18. 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

19. 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

20. 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

21. 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

22. 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 15% $ 7,500
25% $ 6,250
34% $ 8,500
39% $ 90,480
Total taxes $ 112,730
Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

23. 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

24. 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

25. 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
$ (D)
$7, (D)
$13, (D)
$22, (D)
$113, (D)
$3,400, (D)
$5,150, (D)
$6,416, (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

26. Capital Expenditure versus Depreciation Expenses1 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

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

40. 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

41. 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

42. 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

43. 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

44. 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

45. (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

46. (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

47. Step 3 – Create an Income Statement1 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

48. Step 4 – Develop a Cash Flow Statement1 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

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

50. 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

51. 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

52. Question (b): Is this investment justifiable at a MARR of 15%?
PW(15%) = -$148, $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

53. 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

54. 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

55. 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

56. 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

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

58. 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

59. 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

60. 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

61. 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

62. 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

63. 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

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

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

66. 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 % %
Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

67. 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

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

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

70. 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

71. 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

72. 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

73. 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