Chapter 8 PEE

1. 9.2 Income taxes

2. Income Taxes
 Taxes have an effect on cash flow and effect the
investment decisions managers make
 Integrating tax considerations into economic
analysis requires a thorough understanding of
two issues
 How the taxes are imposed
 How taxes affect the economic analysis techniques

3. A Partner(s) in the Business
 Type of tax
 Income tax based on earnings
 Property tax based on property value
 Sales tax based on purchase price
 Use tax based on type of use of an items
 Collected by
 Federal
 Stare
 Country
 City
For simplicity, the text focuses on either
federal income taxes or bundles the tax into
a rate that reflects all taxing entities.
This is done as the taxes at the state or
local level vary widely.

4. Income Taxes
 Calculation of After-Tax Figure of Merit
(General Process)
 Understand the tax laws affecting the project of interest
 Estimate the cash flows without considering the effect of
taxes
 Adjust the cash flows based on the effects of depreciation
and income taxes
 Determine the after-tax measure of merit (PW, IRR,
payback, etc.)
 Calculation of Taxable Income
 Tax laws can be very complex, which can lead to very
complex calculations
 A tax is just another disbursement for services rendered

5. Taxable Income of Business
Firms
 Taxable income = gross income – all
expenditures except capital expenditures
– depreciation and depletion charges

6. Classification of Business
Expenditures
 Capital Expenditures
 Expenditures for depreciable life
 Generally those items having a life in excess of one year
 Expenditures for non-depreciable life
 Generally land, as land has no finite life
 Operating Expenditures
 Materials, labor, overhead, rents, leases, equipment
having a life of less than one year

7. Example 1
 During a 3-year period, a firm had the following
results (in millions of dollars):
 Compute the taxable income for each of the three
years
Year 1 Year 2 Year 3
Gross income form sales $200 $200 $200
Purchase of special tooling
(useful life: 3 years)
-60 0 0
All other expenditures -140 -140 -140
Cash results for the year $0 $0 $0

8. Example 2
 The French Chemical Corporation was formed to produce
household bleach. The firm bought land for $200,000,
hand a $900,000 factory building erected, and installed
$650,000 worth of chemical and packaging equipment.
The pant was completed and operations begun on April
1. the gross income for the calendar year was $450,000.
Supplies and all operating expenses, excluding the
capital expenditures, were $100,000. the firm will use
modified accelerated cost recovery system (MACRS)
application
 What was the first-year depreciation charge?
 What is the first-year taxable income?

9. Income Tax Rates
 Rate change as the taxing authority
requires more or less income
 Income tax rates vary, based on the
taxable income of the business. A small,
highly profitable business might pay more
income tax than a large, unprofitable
business.

10. Economic Analysis Taking
Income Taxes into Account
 Principal elements in the after-tax analysis:
 Before-tax cash flow
 Investment
 Benefits – Cost
 Depreciation
 Taxable income (BTCF – depreciation)
 Income taxes (Taxable income x incremental tax
rate)
 After tax cash flow (BTCF – income taxes)
 IRR

11. Example 3
 A medium-sized profitable corporation is
considering the purchase of a $3000 used
pickup truck for use by the shipping and
receiving department. During the truck’s 5-
year useful life, it is estimated the firm will
save $800 per year after all the costs of owing
and operating the truck have been paid. Truck
salvage value is estimated at $750
 What is the before-tax rate of return
 What is the aster-tax rate of return on this capital
expenditure? Assume straight-line depreciation.

12. Answer:
DEPRECIATION, dt = (3000-750)/5 = 450
Assume Tax rate = 30%
ROR before tax
PWb = PWc
3000 = 800(P/A, i, 5)
; I = bet. 10% - 12 %, please interpolate!!!
ROR after tax
3000 = 695 (P/A, i, 5)
; I = bet. 5% - 6%, please interpolate!!!

13. Example 4
 An analysis of a firm’s sales activities indicates that a
number of profitable sales are lost each year because
the firm cannot deliver same of its products quickly
enough. By investing an additional $20,000 in inventory
it is believed that a firm will realize $1000 more in
before-tax profits in the first year. In the second year,
before-tax extra profit will be $1500. profits for
subsequent years are expected to continue to increase
on a $500-per-year gradient. The investment in the
additional inventory may be recovered at the end of a 4-
year analysis period simply by selling it and not
replenishing the inventory. Compute:
 The before tax rate of return
 The after-tax rate of return assuming an incremental tax
rate of 39%