MER 439

1

• MER 439
• Design of Thermal Fluid Systems
• Basics of Taxation
• Winter Term 2006

2
Taxes

• In this world nothing is certain but death and
  taxes
• -Benjamin Franklin

3
Basics of Taxation For Corporations

• Corporations pay taxes on income generated while
  doing business
• When performing an economic analysis one must
  determine if it is a before or after-tax analysis
• For tax-exempt organizations it is not necessary
• Most analysts do after-tax analyses

4
Definitions

• Gross Income - (GI) Total of all income from
  revenue producing sources
• Expenditures - (E) All costs incurred while
  transacting business
• Taxable Income - (TI) The dollar value remaining
  upon which taxes are to be paid.
• TI Gross Income Expenses Depreciation

5
Example

• During a three year period, a firm had the
  following results (in millions)
• YR1
  YR2 YR3
• Gross income from sales 200 200 200
• Purchase of spec. tooling -60 0
  0
• (Useful life3 yrs)
• All other expenditures -140 -140 -140
• Cash results for the year 0 60 60
• Compute the taxable income for each of the three
  years

6
Example-Solution

• Depreciate special tooling (assuming SL
  depreciation and no SV)
• Annual Depreciation charge
• D (B-SV)/N (60-0)/3 20 million
• TI 200-140-2040 million each yr.

7
Definitions Continued
Capital Gain Gain incurred when the selling
price an asset or real property exceeds the
purchase price (unadjusted basis) Capital Gain
Selling Price Unadjusted Basis STG Short Term
Gain lt 1 yr LTG Long Term Gain gt 1 yr
8
Definitions Continued
Capital Loss Selling Price is Less than
BV Capital Loss BV- Selling Price Short term
(STL), Long Term (LTL) Recaptured Depreciation
RD Selling Price BV gt 0
9
Basic Tax Formulas and Computations
Taxes (GI E D)T TIT T Tax
Rate Corporate Federal Income Tax Rate
Schedule Taxable Income Tax Rate Corporate
Income Tax lt 50,000 15 15 over
0 50,000-75,000 25 7,500 25 over
50,000 75,000-100,000 34 13,75034
over 75,000 100,000-335,000
39 22,25039 over 100k 335,000-10 mil
34 113,90034 over 335k 10 mil-15 mil
35 3.4 mil35 over 10 mil gt15 mil
38 5.159 mil38 over 15 mil
10
Example
A company has a GI 2,750,000 with expenses and
depreciation 1,950,000. Compute the federal
tax. TI 2,750,000-1,950,000 800,000 Taxes
113,900 0.34(800,000-335,000) Taxes
272,000 Average Tax RateTotal taxes
paid/TI 272,000/800,000 0.34
11
Effective Tax Rate

• Accounts for all taxes (federal and state)
• Te state rate (1-state rate)(federal rate)
• That is,
• Te state rate federal rate
• - (state rate)(federal rate)
• TaxesTI x Te

12
Cash Flow Terms
CFBT Cash Flow Before Taxes CFAT Cash Flow
After Taxes CFBTGross Income - Expenditures TI
CFBT Depreciation Taxes TIT CFAT CFBT
- Taxes
13
The Effect of Depreciation on Taxes

• The amount of taxes incurred is affected by the
  depreciation model chosen
• Accelerated methods require less taxes in the
  early years
• Assumptions
• Constant single value tax rate
• CFBT exceeds Annual Depreciation
• Method reduces book value down to same SV
• Same recovery period used (years)
• Then
• Total taxes paid are equal for any depreciation
  models
• The PW of taxes, Ptax, are less for accelerated
  depreciation models

14
Example
Construct the Cash Flow diagram for taxes and
calculate the PW of taxes for a 9000, 5 year
recovery asset if the effective tax rate is 40.
CFBT is estimated at 10,000 per year and the
interest rate is 12 per year, Use the 150
declining balance method of depreciation
15
Solution
d 1.5/n 1.5/5 0.3 B 9000 Dt
dB(1-d)t-1 0.3(9000)(0.7)t-1 Ptaxes
12,094