CHAPTER 6-II

1. CHAPTER 6-II AFTER-TAX ECONOMIC ANALYSIS

2. Learning Objectives • Terminology and Rates • Before- and After-Tax Analysis • Taxes and Depreciation • Depreciation Recapture and Capital Gains • After-Tax Analysis

3. Important Terms • 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

4. Net Profit After Tax (NPAT) • 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

5. Federal Corporate Tax Rates • Corporate Tax Rates: • No one single rate; • Series of “graduated” rates; • 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

6. Marginal Tax Rates • 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%

7. State and Federal • 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

8. Personal vs. Corporate • 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, • Head of household • Individual Tax Rates: Similar bracket design with 5 brackets; 15%, 28%, 31%, 36%, 39.6%

9. CFBT and CFAT • 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!

10. Two or More Depreciation Plans • 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!

11. Capital Gain and Capital Loss • 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.

12. Four Possibilities • 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)

13. Disposal Example • 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)

14. Disposal During the Recovery Period • 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

15. Example • 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)

16. After-Tax Cash Flow Evaluation • 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)

17. Before-Tax MARR • ( 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 ~ ~ - ~ ~

18. ATCF Calculations • 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