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CHAPTER 6-II. AFTER-TAX ECONOMIC ANALYSIS. Learning Objectives. Terminology and Rates Before- and After-Tax Analysis Taxes and Depreciation Depreciation Recapture and Capital Gains After-Tax Analysis. Important Terms. Gross Income

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Chapter 6 ii l.jpg

CHAPTER 6-II

AFTER-TAX ECONOMIC ANALYSIS


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Learning Objectives

  • Terminology and Rates

  • Before- and After-Tax Analysis

  • Taxes and Depreciation

  • Depreciation Recapture and Capital Gains

  • After-Tax Analysis


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Important Terms

  • Gross Income

    • Total income for the tax year from all revenue-producing functions of the enterprise.

  • Income Tax

    • The total amount of money transferred from the enterprise to the various taxing agencies for a given tax year

  • Operating Expenses

    • All costs associated with doing business for the tax year

  • Taxable Income

    • Calculated amount of money for a specified time period from which the tax liability is determined


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Net Profit After Tax (NPAT)

  • 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) = t (Rk-Ek-dk)

  • Amount of money remaining each year when income taxes are subtracted from taxable income

    • NIAT = (Rk-Ek-dk) – t (Rk-Ek-dk)= (1-t) (Rk-Ek-dk)

  • Net profits (if positive) represent funds that are the claim of the owners of the firm

  • NIAT can be:

    • “Saved” by the firm,

    • Reinvested within the firm,

    • Paid out as dividends to the stockholders,

    • Some combination of paying dividends and reinvesting


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Federal Corporate Tax Rates

  • Corporate Tax Rates:

    • No one single rate;

    • Series of “graduated” rates;

    • TI is partitioned into up to 8 brackets of taxable income

    • A tax rate is then applied to each bracket of taxable income and then summed across all applicable brackets.

  • See Table 6-5 for the 8 bracket rates

    • Assume TI = $200,000.

      • 1st $50,000 (0.15) = $7,500($150,000 left)

      • Next $25,000 (0.25) = $6,250($125,000 left)

      • Next $25,000 (0.34) = $8,500($100,000 left)

      • Tax all monies between $100,000 to $335,000 at 34%

      • Last $100,000 (0.34) = $34,000


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Marginal Tax Rates

  • Each bracket rate is termed a “marginal” rate

    • The first $50,000 of TI is taxed at the bracket rate of 15%

    • Any additional TI over $50,000 flows into the next bracket

    • The next $25,000 or part thereof, is taxed at the marginal bracket rate of 25%

    • Each additional $ that moves a firm into a higher bracket is taxed at the higher bracket’s tax rate

  • Total Tax: Add the bracket tax amounts

    • $7,500+6,250+8,500+34,000=$56,250

  • Tax as a % of TI: 56,250/$200,000 = 28.13%


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State and Federal

  • Most states have a state and local corporate tax structure

  • Firms must pay:

    • Federal corporate taxes, and possibly

    • State corporate taxes, and even

    • County or city income taxes.

  • If this is the case, apply a combined tax rate

    • t = state rate + (1 – state rate) (Federal Rate)

  • State income taxes are deductible expenses for federal income tax purposes


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Personal vs. Corporate

  • Individuals must apply the various standard or itemized deductions permitted by current law.

  • Corporations deduct actual cash-flow expenses

  • Individuals have to file as either:

    • Single,

    • Married,

    • Head of household

  • Individual Tax Rates: Similar bracket design with 5 brackets; 15%, 28%, 31%, 36%, 39.6%


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CFBT and CFAT

  • CFBT:

    • Actual real cash flows associated with an investment BEFORE any income tax considerations

  • Next, CFBT will be defined as: gross income –expenses

  • CFBT=Rk-Ek

  • CFAT for a given time period is defined as:

    • CFATk = CFBTk –Tk=(Rk-Ek)- t(Rk-Ek-dk)=(1-t)(Rk-Ek)+ tdk

    • CFATk = NIATk + tdk

  • Focus on (Rk-Ek-dk)

    • For some time periods this term could be negative

    • Operating “loss,” which can generate a “negative” tax

    • Let the sign take care of itself!


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Two or More Depreciation Plans

  • For depreciation plans over the same recovery period, and targeting the same salvage value:

    • The total taxes saved are equal for all depreciation models;

    • The present worth of taxes saved is always less for accelerated depreciation methods

  • Criteria to be used

    • Minimize the PW at some i% over n time periods of the tax;

    • Maximize the PW at some i% over n time periods of the taxes saved

  • If the firm is profitable and the TI amount is > 0, then:

    • Using a depreciation plan that writes off more of the asset in the early years

    • Which can be reinvested at or above the firm’s MARR!


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Capital Gain and Capital Loss

  • Firms sell or dispose of assets from time to time

    • Assets that are disposed do have a book value (Could be + or“0”)

  • Depreciation Recapture (Gain 0n Sale) is defined as:

    • DR = Selling Price – Current Book Value;

  • Capital Gain is defined as:

    • CG = Selling Price – First Cost

    • Certain Assets will gain value over time and could be sold for more than what was originally paid for them.

    • This will generate a tax liability and tax will have to be paid!

  • A capital loss occurs when an asset is sold for less than its current book value.

    • Could generate a tax savings since the “loss” could be tax deductible within certain rules.


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Four Possibilities

  • The asset is sold for a price > BVt

    • SP > BVt generates a tax liability

  • The asset is sold for a price = BVt

    • SP = BVt no tax liability generated

  • The asset is sold for a price < BVt

    • SP < BVt generates a tax savings

  • The asset is sold for a price > Original basis (B)


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Disposal Example

  • An asset was purchased for $10,000, 3 years ago

  • Assume the current BV for tax purposes is $3,000

  • Suppose three different hypothetical selling prices T=34%

  • Assume (SP = $4,000)> (BV = $3,000); DR=1000

    • Tax=1,000 (0.34) = $340;NCFsale = $1,000 – 340 = $660

  • Assume SP = $3,000

    • No tax implications!; NCFSale = $3,000

  • Assume SP = $2,000; loss on disposal= -1000

    • Tax: (-1,000)(0.34) = -$340.00; form of a negative tax!

  • Assume SP = $12,000 and B = $10,000

    • Two Components to deal with:

      • (SP – B) = 12,000 – 10,000 = $2,000 Gain amount (T=0.28)

      • B – BVTime of Sale= $10,000 - $3,000 = $7,000 (T=0.34)


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Disposal During the Recovery Period

  • Under current Federal tax law: Any depreciable asset that is disposed of during the recovery period requires:

    • Only ½ year of the normal depreciation is permitted in the year of disposal

    • The beginning of year book value is reduced by the ½ year of recovery to establish the BV for tax purposes


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Example

  • Assume an asset is in its 4th year of recovery and is sold

    • Assume the beginning of year book value is $5,000

    • Assume the 4th year’s depreciation charge – if not disposed – would be $2,000

    • Only ½ year of recovery is permitted for year 4 or ½ (2,000) = $1,000

    • The book value for tax purposes is BV3 = $5,000 (BOY)

    • Less the $1,000 of permitted recovery due to the half-year rule on disposal, or $4,000.

  • SP, is now compared to the $4,000 BV at the time of sale to determine if there is any recaptured depreciation

  • Expand the TI expression to accommodate depreciation recapture amounts (TI = Rk-Ek-dk +DR + CG – CL)


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After-Tax Cash Flow Evaluation

  • The economic desirability of the cash flow can be determined using PW, FW, AW, ROR, . . .

  • Single Project:

    • PW or AW > 0 at i% or,

    • IROR > MARR

  • Two or More Alternatives:

    • Select the alternative with the largest PW or AW value at the i% rate

    • If using IROR, must apply the incremental analysis approach

  • Some firms may set a before-tax discount rate – MARRBT

  • For after-tax analysis

    • MARRAfter-Tax = MARRBefore Tax(1-t)


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Before-Tax MARR

  • ( Before Tax MARR ) [ ( 1- effective income tax rate ) ] = After Tax MARR

  • After-tax MARR

  • Before-tax MARR = -------------------------

  • ( 1 - effective tax rate )

  • If the asset is non-depreciable and there are no gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact

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ATCF Calculations

  • A tabular approach is suggested

  • See Figure 6-5 and Example 16.16

  • Best performed with a spreadsheet model

  • Depreciation amounts can be calculated in another spreadsheet and copied (values only) into the ATCF worksheet

  • User inputs besides the CF values are the discount rate and the tax rate


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