Lecture # 9 taxes and eva

Lecture # 9
Cost Estimation
Taxes and Economic Value
added (EVA)
17-1 Dr. A. Alim

Income Tax Terminology and Relations for
Corporations (and Individuals)
 Gross Income
 Total income for the tax
year from all revenue
producing function of
the enterprise.
 Sales revenues,
 Fees,
 Rent,
 Royalties,
 Sale of assets
 Income Tax
 The total amount of money
transferred from the
enterprise to the various
taxing agencies for a given
tax year.
 Federal corporate taxes are
normally paid at the end of
every quarter and a final
adjusting payment is
submitted with the tax return
at the end of the fiscal year.
 This tax is based upon the
income producing power of
the firm.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012 17-2 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Terms - continued
 Operating Expenses
 All legally recognized
costs associated with
doing business for the tax
year.
 Real cash flows.
 Taxable Income
 Calculated amount of
money for a specified
time period from
which the tax liability
is determined.
 Calculated as:
 TI = Gross Income –
expenses –
depreciation
TI = GI – E – D

Terms - continued
 Tax rate T
 A percentage or decimal
equivalent of TI.
 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)
 = (TI)(T).
 Net Profit After Tax (NPAT)
 Amount of money remaining each year
when income taxes are subtracted from
taxable income.
NPAT = TI – {(TI)(T)}
= (TI)(1-T)
 Effective tax rate Te combines federal and local
rates:
Total Tax = Federal tax + State tax
State tax is deductable from taxable federal
income, hence : if Tf is federal tax rate, Ts is
state tax rate, and Te is total effective tax rate:
TI (Te ) = TI(Ts) + [TI - TI(Ts)] (Tf)
Te = Tf + Ts – TfTs or Te = Ts + (1-Ts) Tf
Te = Tf + (1-Tf) Ts

Federal Corporate Tax Rates
The rates shown above constitute graduated or progressive tax rates.
Each bracket rate is termed a marginal tax rate.

Example 17.1, page 572, Blank (6th ed.)

International Corporate Tax rates (2011)
Tax rate %
≥ 35
25 - 35
10 - 25
≤ 10
Country
USA, Argentina
Germany, France, Spain, Australia, UK.
Russia, China, Canada, Hungary, UAE
Serbia, Bulgaria, Montenegro

Economy, 7th Edition, 2012
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
17-9
Cash Flow Analysis
Before Taxes and After Taxes

Cash Flow Before Tax (CFBT)
FOR ANY ONE YEAR:
 Cash Flow before Tax (CFBT)
 CFBT = gross income – expenses – initial investment (total
capital) + salvage value + recovered working capital (if any)
 = GI – E – P + S + W
appear year 0 year n
in years
1 to n
 CFBT = - P in year zero
 CFBT = GI – E in years 1 to n-1
 CFBT = GI – E + S + W in year n
 (W is recovered working capital, if any)

Cash Flow After Tax (CFAT)
FOR ANY ONE YEAR:
 Cash Flow After Tax (CFAT)
 CFAT = CFBT – taxes
 CFAT = [GI – E – P + S + W] – (GI – E – D)(Te)
 CFAT = NPAT + D Valid for all years except years 0 and n !
Note: only fixed capital is depreciable, if there is no working capital
then by definition total capital is fixed and is depreciable.
 An evaluation format:
 Table 17.2 , p. 449, Blank (7th ed.)

Table column Headings for Calculation of
CFBT and CFAT
Important Notes:
*) E and P are always negative values.
*) S and possibly working capital (W) appear in last year as positive values
*) P,S, and W appear only in CFBT and CFAT, never in TI.
*) Only fixed capital is depreciated.
*) In a given year, if the depreciation is larger than (GI-E), TI will be
negative resulting in a negative tax, or tax credit.
Plus working capital W , if any
Of fixed capital only !

Calculation of CFBT and CFAT

Example 17.3
YEAR GI E P and S CFBT d D TI TAXES CFAT
0 $0 $0 -$550,000 -$550,000 $0 $0 $0 -$550,000
1 $200,000 -$90,000 $110,000 0.2000 $110,000 $0 $0 $110,000
2 $200,000 -$90,000 $110,000 0.3200 $176,000 -$66,000 -$23,100 $133,100
3 $200,000 -$90,000 $110,000 0.1920 $105,600 $4,400 $1,540 $108,460
4 $200,000 -$90,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676
5 $200,000 -$90,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676
6 $200,000 -$90,000 $150,000 $260,000 0.0576 $31,680 $78,320 $27,412 $232,588
Total $260,000 $550,000 $38,500 $221,500
GI - E - P + S d x 550,000 GI - E - D 0.35xTI CFBT-Taxes

Example 17.3
Y GI - E P and S CFBT d D TI TAXES CFAT NPAT NPAT + D
0 $0 -$550,000 -$550,000 $0 $0 $0 -$550,000 $0 $0
1 $110,000 $110,000 0.2000 $110,000 $0 $0 $110,000 $0 $110,000
2 $110,000 $110,000 0.3200 $176,000 -$66,000 -$23,100 $133,100 -$42,900 $133,100
3 $110,000 $110,000 0.1920 $105,600 $4,400 $1,540 $108,460 $2,860 $108,460
4 $110,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676 $30,316 $93,676
5 $110,000 $110,000 0.1152 $63,360 $46,640 $16,324 $93,676 $30,316 $93,676
6 $110,000 $150,000 $260,000 0.0576 $31,680 $78,320 $27,412 $232,588 $50,908 $82,588
Total $260,000 $550,000 $38,500 $221,500
GI - E - P + S d x 550,000 GI - E - D 0.35xTI CFBT-Taxes TI - Taxes
Note that CFAT does not equal (NPAT+ D) in year 0 and in the last year. CFAT equals (NPAT+D) only in years 1 to (n-1).

Effect on Taxes of Different Depreciation
Methods and Recovery Periods
 Criterion used to compare different depreciation
methods – compute ---
 Objective – Minimize the PW of future taxes paid owing
to a given depreciation method
 For the same salvage value, the total taxes paid are equal for all
depreciation models
 The PW of taxes paid is less for accelerated depreciation methods
 Shorter depreciation periods result in lower PW of future taxes
paid over longer time periods
n
tax
t=1
PW = (taxes in year t)(P/F,i,t)

Effect on Taxes of Different Depreciation
Methods and Recovery Periods

17-18
B = $50,000
n = 5 years
1) SL method
year CFBT = GI - E - P D TI Taxes
0 (50,000.00)$ -$ -$ -$
1 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$
2 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$
3 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$
4 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$
5 20,000.00$ 10,000.00$ 10,000.00$ 3,500.00$
6 20,000.00$ -$ 20,000.00$ 7,000.00$
Total 24,500.00$
PW 18,385.67$

17-19
B = $50,000
n = 5 years
2) DDB method
year CFBT = GI - E - P BV D TI Taxes
0 (50,000.00)$ 50,000.00$ -$ -$ -$
1 20,000.00$ 30,000.00$ 20,000.00$ -$ -$
2 20,000.00$ 18,000.00$ 12,000.00$ 8,000.00$ 2,800.00$
3 20,000.00$ 10,800.00$ 7,200.00$ 12,800.00$ 4,480.00$
4 20,000.00$ 6,480.00$ 4,320.00$ 15,680.00$ 5,488.00$
5 20,000.00$ 3,888.00$ 2,592.00$ 17,408.00$ 6,092.80$
6 20,000.00$ -$ 20,000.00$ 7,000.00$
Total 46,112.00$ 25,860.80$
PW 18,548.61$
Note: Asset is not fully depreciated after 5 years.

17-20
B = $50,000
n = 5 years
3) MACRS method
year CFBT = GI - E - P d D TI Taxes
0 (50,000.00)$
1 20,000.00$ 20.00 10,000.00$ 10,000.00$ 3,500.00$
2 20,000.00$ 32.00 16,000.00$ 4,000.00$ 1,400.00$
3 20,000.00$ 19.20 9,600.00$ 10,400.00$ 3,640.00$
4 20,000.00$ 11.52 5,760.00$ 14,240.00$ 4,984.00$
5 20,000.00$ 11.52 5,760.00$ 14,240.00$ 4,984.00$
6 20,000.00$ 5.76 2,880.00$ 17,120.00$ 5,992.00$
Total 100.00 50,000.00$ 24,500.00$
PW 18,161.96$

Figure 17-2
Comparing Depreciation Plans

Cash flow analysis is important in calculating ROR Before tax and
After tax
 The Rate Of Return (ROR) is a general term used to measure profitability.
 There are several ways to define ROR, e.g.:
* If we ignore time value of money, then ROR is known as Return on Invested Capital (ROI),
In this case, ROR = ROI = Net Profit / Invested capital.
* If we include time value of money, for a series of cash flows,
the ROR is known as IRR (internal rate of return) or discounted cash flow rate of return (DCFRR)
 The rate of return ROR can be calculated using the IRR function for a series of cash flows.
 Rate of return (ROR) can be calculated before tax using CFBT analysis, and/or after tax using CFAT
analysis.
 We therefore have a Before – Tax ROR and an After-Tax ROR. Both may be obtained using the IRR
function.
 An approximate relationship may also be used:
e
after-tax ROR
Tax ROR =
1-T
Before

Example:
A company has spent $50,000 for a 5-year-life machine that has a
projected $20,000 annual CFBT and annual depreciation of
$10,000. The company has a Te of 40%. Determine:
 Exact Before-Tax ROR and After-Tax ROR.
 Approximate Before-Tax ROR

17-26
After-tax and Before-tax Rates of return:
YEAR CFBT Depreciation TI Taxes CFAT
0 -50000 -50000
1 20000 10000 10000 4000 16000
2 20000 10000 10000 4000 16000
3 20000 10000 10000 4000 16000
4 20000 10000 10000 4000 16000
5 20000 10000 10000 4000 16000
ROR 28.65% 18.03%
Before-Tax ROR After-Tax ROR
Approximate Before-Tax ROR = After-Tax ROR / ( 1 - Te)
Equal 0.1803 / (1 - 0.4) = 0.3005 or 30.05%

Cash flows are important for determining
project profitability
 Cash Flow analysis is vital in determining project profitability.
This is particularly true when using annual CFAT values.
 Projects are judged based on PW or AW of their annual CFAT.
Calculated IRR or DCFRR (discounted cash flow rate of return)
are often used as well.
 Another useful criterion for judging profitability is known as the
economic value added (EVA).
 EVA is the increase in NPAT achieved from a ROR above the
MARR. EVA is higher for higher delta between ROR and MARR.

Lecture # 9 taxes and eva

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