BEST USE OF TIME.

What did our Lord Allaah SWT says about using

time?
(1) Engage yourself in learning for full Imaan (life-long deep-wide
learning) [on all aspects of honorable worldly life and eternal life],
and

(2) engage to do righteous deeds accordingly [for yourself, society,

humanity etc.], and

(3) engage to call people in (1)&(2), and

(4) do constant sabr/patience when any difficulty or calamity befalls.

Otherwise, we are potentially losers. (Al-‘Asr 103:1-3).

BASICS ON INCOME TAX

 Income taxes affect a project’s estimated cash flows – major cash outflows,
depreciation, etc.
 Income tax for corporation (before-tax cash flow, BTCF and after-tax cash
flow, ATCF))
 For individual taxpayers
 General approach and fundamental treatment of taxes in engineering economy
analysis
Income tax is frequently changing. Political matter. Tax rates also mechanisms and
allowances.
Terminology:
 Gross income GI, total of all income from revenue-generating sources. For
individual, GI from wages, salaries, interest, dividends, royalties, and capital
gains.
 Adjusted GI: certain allowable adjustments are made.
 Operating expenses, E, all corporation costs incurred in business transaction.
Selected exemptions and deductions for individuals. Operating expenses may
include interest on loans used to operate the business, including the purchase of
capital (depreciable) assets.
 The taxable income for a business in a year is its gross income less the sum of
operating expenses, depreciation, and depletion.
Taxable income, TI: amount upon which taxes are imposed. For corporation:
TI = GI – expenses – depreciation - depletion.
Ex. During one year a business had gross income of $3.2 million, operating expenses
of $2.7 million, depreciation of $0.2 million, and no natural resource depletion. What
is the company's taxable income for the year?

Ex. During one year a business had gross income of $3.2 million, operating expenses
of $2.7 million excluding interest on loans, depreciation of $0.2 million, and no
natural resource depletion. The company had one loan outstanding during the year.
Quarterly payments of $55,000 were made on the loan, $15,000 of which was interest.
What is the company's taxable income for the year?

 Tax rate T: % of taxable income. TI is higher, T is also higher.

Taxes = TI x T
 Net income or profit TI – tax
 Operating losses: net loss rather than a net profit. Balanced lean years by fat
years.
 Capital gain: taxable income when selling price of a depreciable asset exceeds
the original purchase price. Capital gain = selling price – purchase price = +ve
(gain). Short-term gain (STG): gain within a given time of purchase date. LTG:
longer ownership period (1 yr).
 Capital loss: opposite of capital gain = book value – selling price = +ve
(reported).
 Depreciation recapture DR = selling price - book value. If selling price > B or
purchase cost = capital gain and all previous depreciation is recaptured and fully
taxable. S = 0, after recovery period.
 Property taxes on value of property owned, such as land, building, equipment,
and so on. Independent of GI or profits
 Sales tax on purchase goods and/or services, independent of GI or profits (in EE
add to the cost of items purchased)
 Excise taxes on sale of certain goods or services, independent of GI, usually
charged to the manufacturer or original provider.

To fully evaluate an economic analysis taxes must be taken into account. The real
value of an investment is strongly affected by the cost of taxes. As stated in the text
the principal elements in an after-tax analysis are:

 Before-tax cash flow (BTCF)

  Depreciation
 Taxable income (TI = BTCF – Depreciation)
 Income Taxes (TI * Incremental tax rate)
 After-tax Cash Flow (ATCF = BTCF – Income taxes)

Before-Tax and After-Tax MARR

( )[( )

Fundamental Tax Relations

Item General relations to estimate annual income tax
Corporate income tax Individual/family income tax
Gross GI = business revenue + GI = salaries and wages + interest
income, other income and dividends + other income
GI
Taxable TI = gross income – TI = gross income – personal
income, operating expenses – exemption – itemized or standard
TI depreciation - depletion deductions
Income Taxes = TI x tax rate Taxes = TI x tax rate
tax

Table: Corporate income tax rate schedule

(1) (2) (3) (4) = (2)t (5) = sum of
TI limits ($) TI range Tax rate, T Max tax for (4)
TI range Max tax
incurred
1-50,000 50,000 0.15 7,500 7,500
50,001-75,000 25,000 0.25 6,250
75,001-100,000 25,000 0.34 8,500
100,001-335,000 235,000 0.39 91,650
335,001-10 mil 9.665 mil 0.34 3.2861 mil
Over 10 mil – 15 5 mil 0.35 1.75 mil
mil
Over 15 mil- 3.33 mil 0.38 1.267 mil
18.33 mil
Over 18.33 mil unlimited 0.35 unlimited

Table: Individual income tax rate schedule

 (1) (2) (3)
Taxable income
Tax rate, T Filling single Filling married and
jointly
0.15 0-23350 0-39,000
0.28 23,351-56,550 39,001-94,250
0.31 56,551-117,950 94,251,143,600
0.36 117,951-256,500 143,601-256,500
0.396 Over 256,500 Over 256,500

Average tax rate (% of total TI paid) = total tax paid)/(total taxable income =
taxes/TI
Taxes are paid to different authorities. So effective tax rate,
Te =state rate + (1 - city corporation rate) (state/country rate)

It is useful to create a table of these elements:

EoY BTCF Depreciation TI Income tax ATCF

Consider this BTCF where each year the amount is the net for the year for the
particular investment.

EoY BTCF Depreciation TI Income tax ATCF

0 -$3000
1 $800
2 $800
3 $800
4 $800
5 $800
5A $750

Note that for EoY 5 there are two lines; the first is the annual net cash flow and the
second (5A) is an amount received for the salvage value of the asset. Note that these
two together form the BTCF for EoY 5.

To find the IRR for the BTCF, we solve for i below:

3,000 = 800 (P/A, i, 5) + 750 (P/F, i, 5)

Using interest tables and interpolating gives i = 15.7% BT.

Now we need to add the depreciation column. While MACRS is the principal method
used for IRS taxation, it results is a very complex ATCF, so to demonstrate here we
will use straight line depreciation shown in the third column below.

In the fourth column we calculate the taxable income, the difference between BTCF
and depreciation. Note that for EoF 5 the salvage value is not included in the taxable
income. This is because it is a part of the asset basis and has not been depreciated
although it is actually received and is a cash flow.

The fifth column has the actual tax, here using a rate of 34%.

EOY BTCF Depreciation TI Income tax ATCF

0 -$3000
1 $800 $450 $350 -$119
2 $800 $450 $350 -$119
3 $800 $450 $350 -$119
4 $800 $450 $350 -$119
5 $800 $450 $350 -$119
5A $750

The last column, ATCF, is the sum of the BTCF and the income tax; it is the sum
because of the sign convention used: an outflow is negative.

EOY BTCF Depreciation TI Income tax ATCF

0 -$3000 -$3000
1 800 $450 $350 -$119 681
2 800 450 350 -119 681
3 800 450 350 -119 681
4 800 450 350 -119 681
5 800 450 350 -119 681
5A 750 750

Here the total ATCF for EOY5 included the receipt of the salvage value.

To find the IRR for the ATCF, we solve for i below:

3000 = 681 (P/A, i, 5) + 750 (P/F, i, 5)

Using interest tables and interpolating gives i = 10.6% AT.

The equation to get IRR when MACRS is used is much more complex. We will solve
this problem later in this chapter using a spreadsheet.

Ex. For yr 2015, ABC company has GI = $2,750,000 with expenses and
depreciation totaling $1,950,000.
i. Compute the company’s exact state income taxes.
ii. Estimate total state rate and city corporation taxes if the city
corporation rate is 8% and 34% state one-value figure apply.
iii. Estimate the average tax rate for the year for both taxes only and for
total taxes.
Solution:
i. TI = gross income – operating expenses – depreciation = 2,750,000 –
1,950,000 = $800,000
Taxes = TI range x marginal tax rate = 50000 x 0.15 + 25,000 x 0.25 + 25,000
x 0.34 + …
= 272,000
ii. For effective tax rate,
Te = state rate + (1 - city corporation rate)(state/country rate)
= 0.08 + (1- 0.80)(0.34) = 0.3928
Taxes = TI x tax rate = TI x Te = 800,000 x 0.3928
iii. Average tax rate (% of total TI paid) = total tax paid)/(total taxable
income = taxes/TI
State only = 272,000/800,000 = 0.34
State and city corporation = 314,240/800,000 = 0.3928
 Figure: Income tax vs taxable income range at different tax rates

Capital gains and losses for corporation

About disposing of a depreciable asset before, at, or after its recovery period.
When sold MV is seldom equal to its BV.
Gain (loss) on disposal
[ ( )
When gain, it is referred to as depreciation recapture.
When capital asset is sold or exchanged, gain (loss) is known as capital
gain (loss). Ex. Stocks, bonds, gold, silver, etc.
Offsetting Result is considered as Tax treatment
computation
Long-term Net long-term gain Taxed as ordinary TI
LTG-LTL (NLTG) Carry back or
Net long-term loss forward to offset
(NLTL) gain.
Short-term Net short-term gain In economic
LTG-LTL (NSTG) analysis, used only
Net short-term loss to change the size of
(NSTL) net gains or net
losses.
Depreciation recapture, DR
Case I: figure Depreciation recapture Taxed as ordinary TI
(DR) rate

Case II: figure Capital gain plus Both taxed as

depreciation recapture ordinary TI.
(CG + DR)
 From capital sales, final result is net capital gain or loss. Losses do not
reduce taxable income directly.
Depreciation recapture, DR, included in after-tax studies.
Case I: selling price or realized SV in yr t, exceeds the BVt.

Ex. Selling of a building more than the current BV.

Case II: selling price exceeds B. Now,

TI = gross income – operating expenses – depreciation equation now can be

expanded as:
TI = gross income – operating expenses – depreciation +DR+ net capital gain
– net capital losses
If there is a net capital loss, assume that a capital gain will be present in the
same year elsewhere in the corporation to serve as the offset.
Ex. Gross income is $700,000 and all expenses + depreciation is 350,000 in
next tax year. Say Te = 35%. What would be the expected income taxes for:
i. Capital equipment replacements with long-term gains of 35,000 and
long-term losses of 15,000.
ii. Specific anticipated long-term gains 35,000 and long-term losses of
50,000. The company will likely have gains in other areas.
Solution
i. Net LTG of 35,000 – 15,000 = 20,000 is taxed at ordinary rate.
TI = GI – expenses – depreciation + net capital gain = 700,000 –
350,000 + 20,000
Taxes = TI x T
ii. Net long-term loss (NLTL) of 50,000 – 35,000 = 15,000 is not
available to directly reduce TI for the year. It can be used to offset
gains in other parts of the company or net loss may be carried back 3
years or forward 5 years to offset gains in other tax years. As other
 gains are anticipated this year, there will be an effective tax savings,
as tax will not be paid on some other gains due to this offsetting. So,
Taxes = TI x T = (700,000 – 350,000 – 15,000) x (se percentage in
the table) =
Tax savings 15,000 x tax rate =
Net capital losses are usually treated as tax-savings generators and the full
benefit of incurred loss is taken in year it occurs.

Ex. How will taxable income of a corporation be affected if the following gains
and losses are incurred in one tax year?
LTG = 40,000 STG = 75,000 LTL = 75,000 STL = 90,000
Solution: Offsetting gains or losses results in NLTG = 35,000 and NSTL =
15,000. The net result is a long-term gain of 20,000. The TI will increase by
this 20,000 when taxes are imposed.
If long-term gains were taxed at a preferentially lower rate, the 20,000 will be
taxed at this lower rate.

After-Tax economic analysis – general procedure

Use the same profitability analysis as do BT analysis. Only difference, ATCFs
are used instead of BTCFs by including expenses or savings due to income
taxes and then making EW calculations using an after-tax MARR. Procedure
is:
= revenues and savings from the project (cash inflow during period k)
= cash outflows during year k for deductible expenses and interest
= sum of all noncash, or book, costs during year k (depreciation and
depletion)
= effective income tax rate on ordinary income
= income tax consequences during year k.
= from the project during k.
Because net taxable income is , ordinary income tax
consequences during year k are ( )
So, when ( ), a tax liability occurs. Otherwise, a decrease in tax
amount occurs.
The net income after taxes ( ) = taxable income ( ) – income taxes, is
then simply taxable income ( ) algebraically added to the tax amount from
equation ( )
( )
( ) ( )
( )( )
ATCF is ( )( ) (
)( )
ATCFs in year k in terms of BTCFk,
Thus ( ) ( ) ( )(
)
1 2 3 4 5 6
Year BTCF Depreciation Taxable Cash flow for ATCF
income income taxes
k ( ( )(
) )