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# Lecture # 9

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Dr. A. Alim

## Income Tax Terminology and Relations for Corporations (and Individuals)

Gross Income
Total income for the tax

## year from all revenue producing function of the enterprise.

Sales revenues, Fees, Rent, Royalties, Sale of assets

Income Tax The total amount of money transferred from the enterprise to the various taxing agencies for a given tax year.
Federal corporate taxes are

normally paid at the end of every quarter and a final adjusting payment is submitted with the tax return at the end of the fiscal year. This tax is based upon the income producing power of the firm.
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Terms - continued
Operating Expenses
Taxable Income All legally recognized Calculated amount of money for a specified costs associated with time period from doing business for the tax which the tax liability year. is determined. Real cash flows. Calculated as: TI = Gross Income expenses depreciation TI = GI E D
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Terms - continued

Tax rate T A percentage or decimal equivalent of TI. For Federal corporate income tax T is represented by a series of tax rates. The applicable tax rate depends upon the total amount of TI. Taxes owed equals: Taxes = (taxable income) x (applicable rate) = (TI)(T).
Net Profit After Tax (NPAT) Amount of money remaining each year when income taxes are subtracted from taxable income. NPAT = TI {(TI)(T)} = (TI)(1-T) Effective tax rate Te combines federal and local rates: Total Tax = Federal tax + State tax State tax is deductable from taxable federal income, hence : if Tf is federal tax rate, Ts is state tax rate, and Te is total effective tax rate:

## TI (Te ) = TI(Ts) + [TI - TI(Ts)] (Tf)

Te = Tf + Ts TfTs or Te = Ts + (1-Ts) Tf Te = Tf + (1-Tf) Ts
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## Federal Corporate Tax Rates

The rates shown above constitute graduated or progressive tax rates. Each bracket rate is termed a marginal tax rate.
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## Federal Corporate Tax Rates

The rates shown above constitute graduated or progressive tax rates. Each bracket rate is termed a marginal tax rate.
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## Example 17.1, page 572, Blank (6th ed.)

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## International Corporate Tax rates (2011)

Tax rate %
35
25 - 35 10 - 25 10

Country
USA, Argentina
Germany, France, Spain, Australia, UK. Russia, China, Canada, Hungary, UAE Serbia, Bulgaria, Montenegro
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Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012

## Cash Flow Analysis Before Taxes and After Taxes

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## Cash Flow Before Tax (CFBT)

FOR ANY ONE YEAR:
Cash Flow before Tax (CFBT) CFBT = gross income expenses initial investment (total capital) + salvage value + recovered working capital (if any) = GI E P + S + W

appear in years 1 to n

year 0

year n

## (W is recovered working capital, if any)

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## Cash Flow After Tax (CFAT)

FOR ANY ONE YEAR:
Cash Flow After Tax (CFAT) CFAT = CFBT taxes CFAT = [GI E P + S + W] (GI E D)(Te) CFAT = NPAT + D Valid for all years except years 0 and n ! Note: only fixed capital is depreciable, if there is no working capital then by definition total capital is fixed and is depreciable. An evaluation format: Table 17.2 , p. 449, Blank (7th ed.)

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## Table column Headings for Calculation of CFBT and CFAT

Plus working capital W , if any

Important Notes:

## Of fixed capital only !

*) E and P are always negative values. *) S and possibly working capital (W) appear in last year as positive values *) P,S, and W appear only in CFBT and CFAT, never in TI. *) Only fixed capital is depreciated. *) In a given year, if the depreciation is larger than (GI-E), TI will be negative resulting in a negative tax, or tax credit.

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## Calculation of CFBT and CFAT

Example 17.3, page 576, Blank (6th ed.)

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Example 17.3
YEAR 0 1 2 3 4 5 6 Total GI \$0 \$200,000 \$200,000 \$200,000 \$200,000 \$200,000 \$200,000 E P and S CFBT -\$550,000 \$110,000 \$110,000 \$110,000 \$110,000 \$110,000 \$260,000 \$260,000 d D \$0 \$110,000 \$176,000 \$105,600 \$63,360 \$63,360 \$31,680 \$550,000 TI \$0 \$0 -\$66,000 \$4,400 \$46,640 \$46,640 \$78,320 TAXES \$0 \$0 -\$23,100 \$1,540 \$16,324 \$16,324 \$27,412 \$38,500 CFAT -\$550,000 \$110,000 \$133,100 \$108,460 \$93,676 \$93,676 \$232,588 \$221,500 \$0 -\$550,000 -\$90,000 -\$90,000 -\$90,000 -\$90,000 -\$90,000 -\$90,000 \$150,000

## 0.2000 0.3200 0.1920 0.1152 0.1152 0.0576

GI - E - P + S

d x 550,000 GI - E - D

0.35xTI

CFBT-Taxes

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Note that CFAT does not equal (NPAT+ D) in year 0 and in the last year. CFAT equals (NPAT+D) only in years 1 to (n-1).

Example 17.3
Y 0 1 2 3 4 5 6 Total GI - E \$0 \$110,000 \$110,000 \$110,000 \$110,000 \$110,000 \$110,000 P and S -\$550,000 CFBT -\$550,000 \$110,000 \$110,000 \$110,000 \$110,000 \$110,000 \$260,000 \$260,000 d D \$0 \$110,000 \$176,000 \$105,600 \$63,360 \$63,360 \$31,680 \$550,000 TI \$0 \$0 -\$66,000 \$4,400 \$46,640 \$46,640 \$78,320 TAXES \$0 \$0 -\$23,100 \$1,540 \$16,324 \$16,324 \$27,412 \$38,500 CFAT -\$550,000 \$110,000 \$133,100 \$108,460 \$93,676 \$93,676 \$232,588 \$221,500 NPAT \$0 \$0 -\$42,900 \$2,860 \$30,316 \$30,316 \$50,908 NPAT + D \$0 \$110,000 \$133,100 \$108,460 \$93,676 \$93,676 \$82,588

\$150,000

## 0.2000 0.3200 0.1920 0.1152 0.1152 0.0576

GI - E - P + S

d x 550,000

GI - E - D

0.35xTI

CFBT-Taxes TI - Taxes

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## Effect on Taxes of Different Depreciation Methods and Recovery Periods

Criterion used to compare different depreciation methods compute --PWtax = (taxes in year t)(P/F,i,t)
n

Objective Minimize the PW of future taxes paid owing to a given depreciation method
For the same salvage value, the total taxes paid are equal for all

t=1

depreciation models The PW of taxes paid is less for accelerated depreciation methods Shorter depreciation periods result in lower PW of future taxes paid over longer time periods
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## Effect on Taxes of Different Depreciation Methods and Recovery Periods

Example 17.3, page 451, Blank (7th ed.)

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## B = \$50,000 n = 5 years 1) SL method

year 0 1 2 3 4 5 6 CFBT = GI - E - P \$ \$ \$ \$ \$ \$ \$ (50,000.00) 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 D \$ \$10,000.00 \$10,000.00 \$10,000.00 \$10,000.00 \$10,000.00 \$ TI \$ \$10,000.00 \$10,000.00 \$10,000.00 \$10,000.00 \$10,000.00 \$20,000.00 \$ \$ \$ \$ \$ \$ \$ Taxes 3,500.00 3,500.00 3,500.00 3,500.00 3,500.00 7,000.00

Total PW

\$24,500.00 \$18,385.67

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## B = \$50,000 n = 5 years 2) DDB method

year 0 1 2 3 4 5 6 CFBT = GI - E - P \$ \$ \$ \$ \$ \$ \$ (50,000.00) 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 \$ \$ \$ \$ \$ \$ BV D TI Taxes

50,000.00 \$ \$ \$ 30,000.00 \$20,000.00 \$ \$ 18,000.00 \$12,000.00 \$ 8,000.00 \$ 2,800.00 10,800.00 \$ 7,200.00 \$12,800.00 \$ 4,480.00 6,480.00 \$ 4,320.00 \$15,680.00 \$ 5,488.00 3,888.00 \$ 2,592.00 \$17,408.00 \$ 6,092.80 \$ \$20,000.00 \$ 7,000.00

Total PW

\$46,112.00

\$25,860.80 \$18,548.61

## Note: Asset is not fully depreciated after 5 years.

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## B = \$50,000 n = 5 years 3) MACRS method

year 0 1 2 3 4 5 6 CFBT = GI - E - P \$ \$ \$ \$ \$ \$ \$ (50,000.00) 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00 d D TI Taxes

## 20.00 32.00 19.20 11.52 11.52 5.76

\$10,000.00 \$10,000.00 \$ 3,500.00 \$16,000.00 \$ 4,000.00 \$ 1,400.00 \$ 9,600.00 \$10,400.00 \$ 3,640.00 \$ 5,760.00 \$14,240.00 \$ 4,984.00 \$ 5,760.00 \$14,240.00 \$ 4,984.00 \$ 2,880.00 \$17,120.00 \$ 5,992.00

Total PW

100.00

\$50,000.00

\$24,500.00 \$18,161.96

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## Figure 17-2 Comparing Depreciation Plans

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Cash flow analysis is important in calculating ROR Before tax and After tax
The Rate Of Return (ROR) is a general term used to measure profitability. There are several ways to define ROR, e.g.: * If we ignore time value of money, then ROR is known as Return on Invested Capital (ROI), In this case, ROR = ROI = Net Profit / Invested capital. * If we include time value of money, for a series of cash flows, the ROR is known as IRR (internal rate of return) or discounted cash flow rate of return (DCFRR)

The rate of return ROR can be calculated using the IRR function for a series of cash flows.
Rate of return (ROR) can be calculated before tax using CFBT analysis, and/or after tax using CFAT analysis. We therefore have a Before Tax ROR and an After-Tax ROR. Both may be obtained using the IRR function. An approximate relationship may also be used:

## Before Tax ROR =

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## after-tax ROR 1-Te

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Example:
A company has spent \$50,000 for a 5-year-life machine that has a projected \$20,000 annual CFBT and annual depreciation of \$10,000. The company has a Te of 40%. Determine: Exact Before-Tax ROR and After-Tax ROR. Approximate Before-Tax ROR

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## After-tax and Before-tax Rates of return:

YEAR 0 1 2 3 4 5 ROR

Depreciation

TI

Taxes

## 4000 4000 4000 4000 4000

Before-Tax ROR

After-Tax ROR

Approximate Before-Tax ROR = After-Tax ROR / ( 1 - Te) Equal 0.1803 / (1 - 0.4) = 0.3005 or 30.05%
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