This document discusses income taxes and how they are integrated into economic analysis techniques. It covers how business income taxes are calculated based on gross income, operating expenses, depreciation, and tax rates that vary with taxable income levels. It also discusses how personal income taxes are calculated based on gross income, adjustments, exemptions, and deductions. The document provides examples of calculating business and personal income taxes.

1. Chapter 11 - Income Taxes
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EGR 403 Capital Allocation Theory
Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona

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EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch. 3, 4
• Analysis methods
– Ch. 5 - Present Worth
– Ch. 6 - Annual Worth
– Ch. 7,7A,8 - Rate of Return (incremental analysis)
– Ch. 9 - Benefit Cost Ratio & other methods
• Refining the analysis
– Ch. 10, 11 - Depreciation & Taxes
– Ch. 12 - Replacement Analysis

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Income Taxes
• Taxes have an impact on cash flow and affect the
decisions management makes concerning
investments.
• Integrating tax considerations into economic
analysis requires a thorough understanding of two
issues.
– How the taxes are imposed.
– How they affect the economic analysis techniques.

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A Partner(s) in the Business
For simplification 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 in the manner in which they are
administered.
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 item.
Collected by
-Federal
-State
-County
-City

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General Process
• Understand the tax laws affecting the project of
interest.
• Estimate the cash flows without considering the
effect of taxes.
• Adjust the cash flow based on the effects of
depreciation and income taxes.
• Determine the after-tax measure of interest (PW,
IRR, payback, etc.).

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Calculation of Taxable Income
• Tax laws can be very complex leading to
very complex calculations.
• A tax is just another disbursement for
services rendered.

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

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Taxable Income
of Business Firms
• Taxable income = gross income - operating
expenses - depreciation

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Income Tax Rates
• Rates 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.
• US corporate income tax rates are found in
internal revenue service form 1120.

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Example of How to Use Table
• Corporate Before Tax Profit: $15,000,000
• Federal Tax (from tax rate table):
= $3,400,000 + 0.35 ($15,000,000 - $10,000,000)
= $3,400,000 + $1,750,000
= $5, 150,000

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When you sell a capital asset for more than the book
value, it is treated as a profit or a gain and taxes are due

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Economic Analysis Taking Income
Taxes Into Account
Principle elements in the after-tax analysis:
– Before-tax cash flow
• Investment
• Benefits- costs
– Depreciation
– Taxable income (BTCF - depreciation)
– Income taxes (Taxable income x incremental tax rate)
– After tax cash flow (BTCF - income taxes)
– IRR

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Figuring Personal Income Taxes
Gross Income (wages, tips, interest, dividends)
Less: Adjustments (tax deferred investments: 401k, IRA)
= adjusted gross income
Less: exemptions (2750/dependent, includes you)
Less: deductions - choose the most favorable of:
Standard deduction: $4300 if single or $7200 if married (1999)
[Note: $4700 single or $7850 (2002)], or
Itemized deductions (donations, some taxes, interest on your
home, major medical expenses and losses)
= Taxable income
Use tables to determine taxes owed on taxable income.

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Example 1 - Single Student
• Gross Income: $8000
• Adjusted Gross Income: $8000
• Deduction for one exemption: - $2750
• Standard deduction: - $4300 (1999 tax year)
• Taxable income = $950
• Taxes owed = 0.15 * $950 = $142.50

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Example 2 -Young Single Engineer
• Salary: $50,000
• Tax Deferred Investment into 401k: -$5000
• Adjusted Gross Income = $45,000
• One exemption: - $2750
• Standard deduction: - $4300 (1999 tax year)
• Taxable Income = $37,950
• Taxes: $3863.50 + 0.28 ($37,950 - $25750) =
$3863.50 + $3416 = $7279.50

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Young Single Engineer Buys a
Condo
• Cost: $220,000 with down payment of $20,000
• Loan: $200,000, 30 years, 6% nominal
• Monthly Payments: $1199.10 (fixed!)
• Approximate first year interest: $12,000
• Tax savings from $12,000 itemized deduction:
0.28 * $12,000 = $3360
• Property taxes (approx. 2% of value) are also
deductable