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
Taxable Income of Individuals Gross Income - Retirement Contribution - Other adjustments Adjusted Gross Income (AGI) Gross Income Taxable Income
Example 1: Taxable Income Actual cash flows: Taxable Income:
2007 Federal Income Tax Ratesfor Individuals Single Taxpayers
2007 Federal Income Tax Ratesfor Individuals Married Individuals Filing Jointly
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.
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.
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)
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
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
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%
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%
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.
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.
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)