Lecture # 9 taxes and eva

Lecture # 9

Cost Estimation

Taxes and Economic Value added (EVA)

17-1 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.

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 7th Edition, 2012 17-2 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Terms - continued

Operating Expenses

All legally recognized

costs associated with

doing business for the tax

year.

Real cash flows.

Taxable Income Calculated amount of

money for a specified time period from which the tax liability is determined.

Calculated as:

TI = Gross Income – expenses – depreciation

TI = GI – E – D



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



Federal Corporate Tax Rates

The rates shown above constitute graduated or progressive tax rates.

Each bracket rate is termed a marginal tax rate.



Federal Corporate Tax Rates

The rates shown above constitute graduated or progressive tax rates.

Each bracket rate is termed a marginal tax rate.



Example 17.1, page 572, Blank (6th ed.)



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




Economy, 7th Edition, 2012

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 17-9

Cash Flow Analysis

Before Taxes and After Taxes

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 year 0 year n

in years 1 to n

CFBT = - P in year zero

CFBT = GI – E in years 1 to n-1

CFBT = GI – E + S + W in year n (W is recovered working capital, if any)



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.)



Table column Headings for Calculation of

CFBT and CFAT

Important Notes: *) 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.



Plus working capital W , if any

Of fixed capital only !

Calculation of CFBT and CFAT Example 17.3, page 576, Blank (6th ed.)



Example 17.3

YEAR GI E P and S CFBT d D TI TAXES CFAT

0 $0 $0 -$550,000 -$550,000 $0 $0 $0 -$550,000

1 $200,000 -$90,000 $110,000 0.2000 $110,000 $0 $0 $110,000

2 $200,000 -$90,000 $110,000 0.3200 $176,000 -$66,000 -$23,100 $133,100

3 $200,000 -$90,000 $110,000 0.1920 $105,600 $4,400 $1,540 $108,460

4 $200,000 -$90,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676

5 $200,000 -$90,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676

6 $200,000 -$90,000 $150,000 $260,000 0.0576 $31,680 $78,320 $27,412 $232,588

Total $260,000 $550,000 $38,500 $221,500

GI - E - P + S d x 550,000 GI - E - D 0.35xTI CFBT-Taxes



Example 17.3

Y GI - E P and S CFBT d D TI TAXES CFAT NPAT NPAT + D

0 $0 -$550,000 -$550,000 $0 $0 $0 -$550,000 $0 $0

1 $110,000 $110,000 0.2000 $110,000 $0 $0 $110,000 $0 $110,000

2 $110,000 $110,000 0.3200 $176,000 -$66,000 -$23,100 $133,100 -$42,900 $133,100

3 $110,000 $110,000 0.1920 $105,600 $4,400 $1,540 $108,460 $2,860 $108,460

4 $110,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676 $30,316 $93,676

5 $110,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676 $30,316 $93,676

6 $110,000 $150,000 $260,000 0.0576 $31,680 $78,320 $27,412 $232,588 $50,908 $82,588

Total $260,000 $550,000 $38,500 $221,500

GI - E - P + S d x 550,000 GI - E - D 0.35xTI CFBT-Taxes TI - Taxes



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).

Effect on Taxes of Different Depreciation

Methods and Recovery Periods

Criterion used to compare different depreciation methods – compute ---

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

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

n

tax

t=1

PW = (taxes in year t)(P/F,i,t)



Effect on Taxes of Different Depreciation

Methods and Recovery Periods

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






B = $50,000

n = 5 years

1) SL method

year CFBT = GI - E - P D TI Taxes

0 (50,000.00)$ -$ -$ -$

1 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$

2 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$

3 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$

4 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$

5 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$

6 20,000.00$ -$ 20,000.00$ 7,000.00$

Total 24,500.00$

PW 18,385.67$




B = $50,000

n = 5 years

2) DDB method

year CFBT = GI - E - P BV D TI Taxes

0 (50,000.00)$ 50,000.00$ -$ -$ -$

1 20,000.00$ 30,000.00$ 20,000.00$ -$ -$

2 20,000.00$ 18,000.00$ 12,000.00$ 8,000.00$ 2,800.00$

3 20,000.00$ 10,800.00$ 7,200.00$ 12,800.00$ 4,480.00$

4 20,000.00$ 6,480.00$ 4,320.00$ 15,680.00$ 5,488.00$

5 20,000.00$ 3,888.00$ 2,592.00$ 17,408.00$ 6,092.80$

6 20,000.00$ -$ 20,000.00$ 7,000.00$

Total 46,112.00$ 25,860.80$

PW 18,548.61$

Note: Asset is not fully depreciated after 5 years.




B = $50,000

n = 5 years

3) MACRS method

year CFBT = GI - E - P d D TI Taxes

0 (50,000.00)$

1 20,000.00$ 20.00 10,000.00$ 10,000.00$ 3,500.00$

2 20,000.00$ 32.00 16,000.00$ 4,000.00$ 1,400.00$

3 20,000.00$ 19.20 9,600.00$ 10,400.00$ 3,640.00$

4 20,000.00$ 11.52 5,760.00$ 14,240.00$ 4,984.00$

5 20,000.00$ 11.52 5,760.00$ 14,240.00$ 4,984.00$

6 20,000.00$ 5.76 2,880.00$ 17,120.00$ 5,992.00$

Total 100.00 50,000.00$ 24,500.00$

PW 18,161.96$



Figure 17-2

Comparing Depreciation Plans





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:

e

after-tax ROR Tax ROR =

1-TBefore



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






After-tax and Before-tax Rates of return:

YEAR CFBT Depreciation TI Taxes CFAT

0 -50000 -50000

1 20000 10000 10000 4000 16000

2 20000 10000 10000 4000 16000

3 20000 10000 10000 4000 16000

4 20000 10000 10000 4000 16000

5 20000 10000 10000 4000 16000

ROR 28.65% 18.03%

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%

Cash flows are important for determining

project profitability

Cash Flow analysis is vital in determining project profitability.

This is particularly true when using annual CFAT values.

Projects are judged based on PW or AW of their annual CFAT.

Calculated IRR or DCFRR (discounted cash flow rate of return)

are often used as well.

Another useful criterion for judging profitability is known as the

economic value added (EVA).

EVA is the increase in NPAT achieved from a ROR above the

MARR. EVA is higher for higher delta between ROR and MARR.



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Lecture # 9 taxes and eva