Chapter 7b income taxes
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Chapter 7B Income Taxes. A Partner in the Business. Consider U.S. Government as a partner in every business activity Government shares in the profits from every successful venture through income taxes Government shares in the losses of unprofitable venture through income taxes.

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Chapter 7b income taxes l.jpg

Chapter 7BIncome Taxes


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A Partner in the Business

  • Consider U.S. Government as a partner in every business activity

  • Government shares in the profits from every successful venture through income taxes

  • Government shares in the losses of unprofitable venture through income taxes


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Taxable Income of Individuals

Gross Income

- Retirement Contribution

- Other adjustments

Adjusted Gross Income (AGI)

Gross Income

Taxable Income



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Classification ofBusiness Expenditures



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Example 1: Taxable Income

Actual cash flows:

Taxable Income:



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2007 Federal Income Tax Ratesfor Individuals

Single Taxpayers


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2007 Federal Income Tax Ratesfor Individuals

Married Individuals Filing Jointly


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Example 2:Taxable Income of Individuals

An unmarried student earned $10,000 in the summer plus another $6000 during the rest of the year. He is allowed one exemption and he spent $1000 on allowable itemized deductions.



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2007 Federal Corporate Income Tax Rates


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Average Federal Corporate Income Tax Rates


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Example 3: Federal Corporate Income Tax

The French Chemical Corp. bought land for $220,000, built a $900,000 factory building, and installed $650,000 worth of chemical equipment. The plant was completed and operation begun on April 1. Gross income for the calendar year was $450,000. All expenses amounted to $100,000. The firm used MACRS for depreciation.


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Combined Federal and State Income Taxes

  • The amount of state taxes paid is deductible in calculating the taxable income for federal taxes

  • Federal income taxes are not deductible in the computation of state taxable income

Combined incremental tax rate

= State tax rate + (Federal tax rate)(1 - State tax rate)


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Selecting an Income Tax Rate for Economy Studies

  • The tax rate to use is the incremental tax rate that applies to the change in taxable income projected in the economic analysis


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Economic Analysis taking Income Tax into Account

  • Before-tax cash flow

  • Depreciation

  • Taxable income = Before-tax cash flow - Depreciation

  • Income taxes = Taxable income x Incremental tax rate

  • After-tax cash flow = Before-tax cash flow - Income taxes


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Example 4: Calculation of After-tax Cash Flows

Initial Cost = $3000; Useful life = 5 years;

Annual net saving= $800; Salvage value = $750;

IRRAT=10.6%

IRRBT=15.7%


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Example 5: Calculation of After-tax Cash Flows

Initial Cost (inventory) = $20000; Useful life = 4 years;

Annual net saving= $1000, 1500…; Salvage value = $20000;

IRRAT= 5.2%

IRRBT= 8.5%


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Capital Gains and Losses for Non-depreciated Assets

  • If the selling price of the capital asset exceeds the original cost basis, the excess is called capital gain.

  • If the selling price of the capital asset is less than the original cost basis, the difference is a capital loss.


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Tax Treatment of Capital Gains and Losses


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Investment Tax Credit (ITC)

  • ITC has been used to stimulate capital investments.

  • Businesses were able to deduct a percentage of their new equipment purchases as a tax credit.

  • Depending on the specific ITC provisions, the credit might or might not be subtracted from the basis for depreciation.

  • Tax Reform Act of 1986 eliminated ITC for most assets, although credits are allowed in some specialized cases, such as historical building preservation and in the development of alternate energy sources.


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Estimating the After-Tax Rate of Return

  • For non-depreciable assets

    After-tax rate of return

    = (1 – Incremental tax rate) (Before-tax rate of return)


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