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OUTLINE

OUTLINE. Questions? News? Depreciation Taxes. Example 7.13 Incremental Analysis for Cost-Only Projects. Incremental Cash Flow (FMS – CMS). Solution:. Example 7.14 IRR Analysis for Projects with Different Lives. MARR = 15% The incremental cash flows (Model B – Model A) result

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OUTLINE

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  1. OUTLINE • Questions? • News? • Depreciation • Taxes

  2. Example 7.13 Incremental Analysis for Cost-Only Projects

  3. Incremental Cash Flow (FMS – CMS)

  4. Solution:

  5. Example 7.14 IRR Analysis for Projects with Different Lives MARR = 15% • The incremental cash flows (Model B – Model A) result in a nonsimple and mixed investment. • RICB–A = 50.68% > 15% • Select Model B

  6. COST BASIS • COST BASIS IS: • THE TOTAL COST OF THE ASSET OVER ITS LIFE • INITIAL INVESTMENT • FREIGHT • SITE PREPARATION • INSTALLATION • TRADE-IN ALLOWANCE OF THE PREVIOUS EQUIPMENT • IT DOES NOT INCLUDE OPERATING EXPENSES

  7. OTHER DEFINITIONS • THE BOOK VALUE EQUALS THE COST BASIS LESS THE ACCUMULATED TOTAL DEPRECIATION • SALVAGE VALUE - ESTIMATED VALUE AT THE END OF AN ASSET’S LIFE • DEPRECIABLE LIFE - NUMBER OF YEARS THAT THE ASSET CAN BE USED • ASSET DEPRECIATION RANGE (ADR) - PRESCRIBED GUIDELINES BY THE IRS FOR DEPRECIABLE LIFE • IRS - INTERNAL REVENUE SERVICE -- ENFORCES TAX RULES CREATED BY CONGRESS AND COLLECTS THE TAXES

  8. DEPRECIATION METHODS • DEPRECIATION IS CALCULATED TWO WAYS, EACH WITH ITS OWN PURPOSES • BOOK DEPRECIATION • FINANCIAL REPORTS • INCOME STATEMENTS • REFLECTS ACTUAL LOSS IN VALUE • STATE TAXES AND FEDERAL TAXES BEFORE 1981 • TAX DEPRECIATION • TO CALCULATE TAXES FOR THE IRS • TAKES ADVANTAGE OF TAX RULES • USUALLY LEADS TO BETTER CASH POSITION IN EARLIER YEARS

  9. BOOK DEPRECIATION METHODS • STRAIGHT LINE (SL) • ACCELERATED • DECLINING BALANCE (DB) • DECLINING BALANCE WITH CONVERSION TO SL • UNIT OF PRODUCTION • DEPLETION

  10. DECLINING BALANCE METHOD • USES A FIXED FRACTION (alpha) OF THE BEGINNING BOOK BALANCE EACH YEAR: • MULTIPLIERS: • 1.5 OR 150% DB • 2.0 OR 200% OR DOUBLE DECLINING METHOD (DDB)

  11. DECLINING BALANCE WITH CONVERSION TO STRAIGHT LINE • WHAT DO WE DO IF THE DB METHOD DOES NOT RESULT IN THE ESTIMATED SALVAGE VALUE? 1. IF BN > S • WE HAVE NOT DEPRECIATED THE ASSET FULLY • SWITCH TO STRAIGHT LINE THE FIRST YEAR THAT THE STRAIGHT LINE DEPRECIATION IS GREATER THAN THE DB METHOD 2. BN < S • STOP DEPRECIATING WHEN YOU GET TO S EXAMPLES 9.3 AND 9.4

  12. Example 9.3 • Cost basis of the asset I = $10,000 • Useful life N = 5 years • Estimated salvage value S = $2,000

  13. Example 9.4 –Declining Balance • Cost basis of the asset I = $10,000 • Useful life N = 5 years • Estimated salvage value, S = $778 • D1 =

  14. Changing to straight line WE DID NOT DEPRECIATE THE ASSET FULLY AND MUST SWITCH TO STRAIGHT LINE

  15. UNITS - OF - PRODUCTION METHOD • ALLOCATES THE DEPRECIATION IN PROPORTION TO THE UNITS PRODUCED AS A FRACTION OF THE TOTAL UNITS EXAMPLE 9.7

  16. HISTORY OF DEPRECIATION METHODS • UNTIL 1954 - STRAIGHT LINE ONLY • 1954 - 1981 --ADDED ACCELERATED METHODS: • DECLINING BALANCE (DB) • DOUBLE DECLINING METHOD (DDB) • SUM OF THE YEARS’ DIGITS (SOYD) (WE DID NOT COVER) • 1981 • REPLACED BY ACCELERATED COST RECOVERY SYSTEM (ACRS) • 1986 MODIFIED ACRS = MACRS

  17. MODIFIED ACCELERATED RECOVERY SYSTEM (MACRS) • SALVAGE VALUE ALWAYS ZERO • RECOVERY PERIOD -- ARBITRARY LIFE FOR THE INVESTMENT, NOT NECESSARILY EQUAL TO ACTUAL LIFE • EIGHT CATEGORIES: 3, 5, 7, 10, 15, 20, 27.5, 39 YEARS • 3, 5, 7 AND 10 YEARS - USE 200%DDB, SWITCH TO SL • 15 AND 20 YEARS -- USE 150%DDB AND SWITCH TO SL • 27.5 YEARS RESIDENTIAL RENTAL -- SL • 39 YEARS COMMERCIAL BUILDINGS -- SL • USE TABLE 9.3 ON PAGE 448

  18. MACRS TABLE

  19. HALF YEAR CONVENTION • FOR EQUIPMENT PLACED IN SERVICE USING MACRS: • ALL ASSETS ARE ASSUMED TO BE PLACED IN SERVICE IN THE MIDDLE OF THE YEAR • ALL SALVAGE VALUE IS ZERO • ONLY A HALF YEARS’ DEPRECIATION IS ALLOWED THE FIRST YEAR • THE REMAINING HALF YEAR IS ALLOWED FOLLOWING THE END OF THE RECOVERY PERIOD • FOR REAL PROPERTY, USE MID - MONTH INSTEAD OF HALF YEAR

  20. EXAMPLE 9.8 • ASSET = $10,000 MACRS CLASS 5 YEARS

  21. DEPLETION • APPLIES TO NATURAL RESOURCES • OBJECTIVE IS THE SAME AS DEPRECIATION • COST DEPLETION WORKS JUST LIKE UNITS OF PRODUCTION - EQUATION 9.9: COST DEPLETION =(ADJUSTED BASIS OF MINERAL PROPERTY)x(NUMBER OF UNITS SOLD) / (TOTAL NUMBER OF RECOVERABLE UNITS) EXAMPLE 9.10 • PERCENTAGE DEPLETION - PORTION OF GROSS INCOME, LIMITED BY 50% OF THE TAXABLE INCOME WITHOUT THE DEPLETION • ALLOWABLE PERCENTAGES ARE GIVEN IN TABLE 9.5. THESE RANGE FROM 5% TO 22% EXAMPLE 9.11

  22. Cost depletion vs. percentage depletion

  23. REPAIRS OR IMPROVEMENTS • For tax depreciation purposes, repairs or improvements made to any property are treated as separate property items. • The recovery period for a repair or improvement to the initial property normally begins on the date the repaired or improved property is placed in service. • The recovery class of the repair or improvement is the recovery class that would apply to the property if it were placed in service at the same time as the repair or improvement. • Example 9.12 (modified)

  24. EXAMPLE 9.12 • In January 2004, Kendall Manufacturing Company purchased a new numerical control machine at a cost of $60,000. The machine had an expected life of 10 years at the time of purchase and a zero expected salvage value at the end of the 10 years. • For book depreciation purposes, no major overhauls had been planned over the 10-year period, and the machine was being depreciated toward a zero salvage value, or $6,000 per year, with the straight-line method. • For tax purposes, the machine was classified as a 7-year MACRS property.

  25. EXAMPLE 9.12 CONTINUED

  26. EXAMPLE 9.12 CONTINUED • In December 2006, however, the machine was thoroughly overhauled and rebuilt at a cost of $15,000. It was estimated that the overhaul would extend the machine’s useful life by 5 years.

  27. EXAMPLE 9.12 CONTINUED

  28. INCOME TAXES • OUTLINE • NET INCOME • CORPORATE INCOME TAXES • OPERATING INCOME • CAPITAL GAINS AND LOSSES • TAX TREATMENT OF DEPRECIABLE ITEMS • INCOME TAX RATE IN ECONOMIC ANALYSIS

  29. NET INCOME • REVENUES - MONEY GENERATED BY A PROJECT • EXPENSES OR COSTS - INCURRED BY THE PROJECT • PROFIT = INCOME = REVENUES LESS COSTS (LOSS IF NEGATIVE) • TAXABLE INCOME = REVENUES LESS EXPENSES • INCOME TAX = TAX RATE TIMES TAXABLE INCOME • NET INCOME = INCOME LESS TAXES (DEPRECIATION IS A COST, BUT NOT A CASH OUTLAY) • CASH FLOW = ACTUAL MONEYS BEING RECEIVED AND EXPENDED

  30. CORPORATE INCOME TAXES • TABLE 11.1 RANGES FROM 15% TO 35% WITH SOME SURTAXES (X IS THE AMOUNT OF INCOME) – SEE NEXT SLIDE • EFFECTIVE TAX RATE = TAXES PAID DIVIDED BY TAXABLE INCOME • CAPITAL GAIN OR LOSS = DIFFERENCE BETWEEN THE BOOK VALUE AND THE ACTUAL AMOUNT RECEIVED WHEN THE ITEM IS SOLD (SEE SLIDE 6 FOR EXAMPLE) • THESE MAY BE USED TO OFFSET EACH OTHER AND LOSSES CARRIED TO THE FOLLOWING YEAR, BUT CANNOT BE USED TO OFFSET ORDINARY INCOME. THEY ARE TAXED AT THE SAME RATE AS ORDINARY INCOME

  31. Corporate Income Tax Rates

  32. Capital Gains and Ordinary gains

  33. INCOME TAX RATE IN ECONOMIC ANALYSIS • WHAT TAX RATE DO YOU USE WHEN EVALUATING A PROJECT? • INCREMENTAL TAX RATE = (NEW TAXES LESS OLD TAXES) / ADDITIONAL INCOME

  34. STATE INCOME TAXES • STATE INCOME TAXES ARE DEDUCTIBLE FROM FEDERAL INCOME AS AN EXPENSE • PREFERRED METHOD: 1. CALCULATE STATE TAXES DUE TO PROJECT 2. REDUCE FEDERAL TAXABLE INCOME (INCLUDING PROJECT) BY THE STATE TAX 3. CALCULATE FEDERAL TAXES 4. CALCULATE INCREMENTAL RATE (OR TOTAL TAXES)

  35. Example • Gross Revenue $1,000,000 • All Expenses $400,000 • Federal Tax rate = See Table • State Tax rate = 7% • State Income tax = 0.07*(1000000-400000) = $42,000 • Federal Taxable Income = 1,000,000 – 400,000 – 42,000 = 558,000 • Federal Tax = 113,900 + 0.34*(558,000 – 335,000) = $189,720 • Total Taxes = $231,720 • Combined Tax rate = 231,720 / 600,000 = 38.62% or • =.34 + .07 - .34*.07 = .3862

  36. Example

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