The document discusses income taxes and their impact on economic analysis and capital allocation decisions. It notes that taxes affect cash flows and management decisions regarding investments. Integrating taxes requires understanding how they are imposed and how they affect analysis techniques. The general process involves understanding applicable tax laws, estimating pre-tax cash flows, adjusting cash flows for taxes and depreciation, and determining after-tax measures of return. Capital expenses that can be depreciated and operating expenses are also classified.

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
– Sanjeev Ghai Income Tax

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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.

4. EGR 403 - Cal Poly Pomona - SA14 4
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.

7. EGR 403 - Cal Poly Pomona - SA14 7
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