6.2 Income Taxes

8/2/2019 6.2 Income Taxes

1/12


2/12

Taxes have an effect on cash flow and effectthe investment decisions managers make

Integrating tax considerations into

economic analysis requires a thoroughunderstanding of two issues How the taxes are imposed

How taxes affect the economic analysis

techniques


3/12

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 items

Collected by Federal

Stare Country City

For simplicity, the text focuses on eitherfederal 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.


4/12

Calculation of After-Tax Figure of Merit(General Process) Understand the tax laws affecting the project of

interest Estimate the cash flows without considering the

effect of taxes Adjust the cash flows based on the effects of

depreciation and income taxes Determine the after-tax measure of merit (PW,

IRR, payback, etc.) Calculation of Taxable Income

Tax laws can be very complex, which can leadto very complex calculations

A tax is just another disbursement for services

rendered


5/12

Taxable income

= gross income all expenditures

except capital expenditures depreciation and depletion charges


6/12

Capital Expenditures Expenditures for depreciable life

Generally those items having a life in excess of

one year Expenditures for non-depreciable life

Generally land, as land has no finite life

Operating Expenditures Materials, labor, overhead, rents, leases,

equipment having a life of less than oneyear


7/12

During a 3-year period, a firm had thefollowing results (in millions of dollars):

Compute the taxable income for each of thethree years

Year 1 Year 2 Year 3

Gross income form sales $200 $200 $200

Purchase of special tooling(useful life: 3 years)

-60 0 0

All other expenditures -140 -140 -140

Cash results for the year $0 $0 $0


8/12

The French Chemical Corporation was formed toproduce household bleach. The firm boughtland for $200,000, hand a $900,000 factorybuilding erected, and installed $650,000 worthof chemical and packaging equipment. The pant

was completed and operations begun on April 1.the gross income for the calendar year was$450,000. Supplies and all operating expenses,excluding the capital expenditures, were$100,000. the firm will use modified accelerated

cost recovery system (MACRS) application What was the first-year depreciation charge? What is the first-year taxable income?


9/12

Rate change as the taxing authority requiresmore or less income

Income tax rates vary, based on the taxable

income of the business. A small, highlyprofitable business might pay more incometax than a large, unprofitable business.


10/12

Principal elements in the after-taxanalysis: Before-tax cash flow

Investment Benefits Cost

Depreciation

Taxable income (BTCF depreciation)

Income taxes (Taxable income xincremental tax rate)

After tax cash flow (BTCF income taxes)

IRR


11/12

A medium-sized profitable corporation isconsidering the purchase of a $3000 usedpickup truck for use by the shipping andreceiving department. During the trucks 5-year useful life, it is estimated the firm will

save $800 per year after all the costs ofowing and operating the truck have beenpaid. Truck salvage value is estimated at$750

What is the before-tax rate of returnWhat is the aster-tax rate of return on this capitalexpenditure? Assume straight-line depreciation.


12/12

An analysis of a firms sales activities indicates

that a number of profitable sales are lost eachyear because the firm cannot deliver same of itsproducts quickly enough. By investing anadditional $20,000 in inventory it is believed thata firm will realize $1000 more in before-taxprofits in the first year. In the second year,before-tax extra profit will be $1500. profits forsubsequent years are expected to continue toincrease on a $500-per-year gradient. Theinvestment in the additional inventory may berecovered at the end of a 4-year analysis period

simply by selling it and not replenishing theinventory. Compute:The before tax rate of returnThe after-tax rate of return assuming an incremental taxrate of 39%

Documents

6.2 Income Taxes