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Chapter 11 - Income Taxes Click here for Streaming Audio To Accompany Presentation (optional). EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona. EGR 403 - The Big Picture. Framework: Accounting & Breakeven Analysis

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chapter 11 income taxes click here for streaming audio to accompany presentation optional

Chapter 11 - Income TaxesClick here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department

Cal Poly Pomona

egr 403 the big picture
EGR 403 - The Big Picture
  • Framework:Accounting& Breakeven Analysis
  • “Time-value of money” concepts - Ch. 3, 4
  • Analysis methods
    • Ch. 5 - Present Worth
    • Ch. 6 - Annual Worth
    • Ch. 7,7A,8 - Rate of Return (incremental analysis)
    • Ch. 9 - Benefit Cost Ratio & other methods
  • Refining the analysis
    • Ch. 10, 11 - Depreciation & Taxes
    • Ch. 12 - Replacement Analysis

EGR 403 - Cal Poly Pomona - SA14

income taxes
Income Taxes
  • Taxes have an impact on cash flow and affect the decisions management makes concerning investments.
  • Integrating tax considerations into economic analysis requires a thorough understanding of two issues.
    • How the taxes are imposed.
    • How they affect the economic analysis techniques.

EGR 403 - Cal Poly Pomona - SA14

a partner s in the business
A Partner(s) in the Business
  • Type of tax
    • Income tax based on earnings
    • Property tax based on property value
    • Sales tax based on purchase price
    • Use tax based on type of use of an item.
  • Collected by
    • Federal
    • State
    • County
    • City

For simplification the text focuses on either Federal Income taxes or bundles the tax into a rate that reflects all taxing entities. This is done as the taxes at the state or local level vary widely in the manner in which they are administered.

EGR 403 - Cal Poly Pomona - SA14

general process
General Process
  • Understand the tax laws affecting the project of interest.
  • Estimate the cash flows without considering the effect of taxes.
  • Adjust the cash flow based on the effects of depreciation and income taxes.
  • Determine the after-tax measure of interest (PW, IRR, payback, etc.).

EGR 403 - Cal Poly Pomona - SA14

calculation of taxable income
Calculation of Taxable Income
  • Tax laws can be very complex leading to very complex calculations.
  • A tax is just another disbursement for services rendered.

EGR 403 - Cal Poly Pomona - SA14

classification of business expenditures
Classification ofBusiness Expenditures
  • Capital expenses.
    • Expenditures for depreciable assets.
      • Generally those items having a life in excess of one year.
    • Expenditures for non-depreciable assets.
      • Generally land, as land has no finite life.
  • Operating expenses.
    • Materials, labor, overhead, rents, leases, equipment having a life of less than one year.

EGR 403 - Cal Poly Pomona - SA14

taxable income of business firms
Taxable Income of Business Firms
  • Taxable income = gross income - operating expenses - depreciation

EGR 403 - Cal Poly Pomona - SA14

income tax rates
Income Tax Rates
  • Rates change as the taxing authority requires more or less income.
  • Income tax rates vary, based on the taxable income of the business. A small highly profitable business might pay more income tax than a large unprofitable business.
  • US corporate income tax rates are found in internal revenue service form 1120.

EGR 403 - Cal Poly Pomona - SA14

example of how to use table
Example of How to Use Table
  • Corporate Before Tax Profit: $15,000,000
  • Federal Tax (from tax rate table):

= $3,400,000 + 0.35 ($15,000,000 - $10,000,000)

= $3,400,000 + $1,750,000

= $5, 150,000

EGR 403 - Cal Poly Pomona - SA14

slide14
When you sell a capital asset for more than the book value, it is treated as a profit or a gain and taxes are due

EGR 403 - Cal Poly Pomona - SA14

economic analysis taking income taxes into account
Economic Analysis Taking Income Taxes Into Account

Principle elements in the after-tax analysis:

  • Before-tax cash flow
    • Investment
    • Benefits- costs
  • Depreciation
  • Taxable income (BTCF - depreciation)
  • Income taxes (Taxable income x incremental tax rate)
  • After tax cash flow (BTCF - income taxes)
  • IRR

EGR 403 - Cal Poly Pomona - SA14

figuring personal income taxes
Figuring Personal Income Taxes

Gross Income (wages, tips, interest, dividends)

Less: Adjustments (tax deferred investments: 401k, IRA)

= adjusted gross income

Less: exemptions (2750/dependent, includes you)

Less: deductions - choose the most favorable of:

Standard deduction: $4300 if single or $7200 if married (1999) [Note: $4700 single or $7850 (2002)], or

Itemized deductions (donations, some taxes, interest on your home, major medical expenses and losses)

= Taxable income

Use tables to determine taxes owed on taxable income.

EGR 403 - Cal Poly Pomona - SA14

example 1 single student
Example 1 - Single Student
  • Gross Income: $8000
  • Adjusted Gross Income: $8000
  • Deduction for one exemption: - $2750
  • Standard deduction: - $4300 (1999 tax year)
  • Taxable income = $950
  • Taxes owed = 0.15 * $950 = $142.50

EGR 403 - Cal Poly Pomona - SA14

example 2 young single engineer
Example 2 -Young Single Engineer
  • Salary: $50,000
  • Tax Deferred Investment into 401k: -$5000
  • Adjusted Gross Income = $45,000
  • One exemption: - $2750
  • Standard deduction: - $4300 (1999 tax year)
  • Taxable Income = $37,950
  • Taxes: $3863.50 + 0.28 ($37,950 - $25750) = $3863.50 + $3416 = $7279.50

EGR 403 - Cal Poly Pomona - SA14

young single engineer buys a condo
Young Single Engineer Buys a Condo
  • Cost: $220,000 with down payment of $20,000
  • Loan: $200,000, 30 years, 6% nominal
  • Monthly Payments: $1199.10 (fixed!)
  • Approximate first year interest: $12,000
  • Tax savings from $12,000 itemized deduction: 0.28 * $12,000 = $3360
  • Property taxes (approx. 2% of value) are also deductable

EGR 403 - Cal Poly Pomona - SA14