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# CHAPTER 6-II - PowerPoint PPT Presentation

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

AFTER-TAX ECONOMIC ANALYSIS

• Terminology and Rates

• Before- and After-Tax Analysis

• Taxes and Depreciation

• Depreciation Recapture and Capital Gains

• After-Tax Analysis

• 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

• 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

• Corporate Tax Rates:

• No one single rate;

• 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

• 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%

• 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

• 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,

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

• 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!

• 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!

• 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.

• 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)

• 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)

• 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

• 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)

• 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)

• ( 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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• 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