Engineering Economic Analysis Canadian Edition

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Engineering Economic AnalysisCanadian Edition

• Chapter 12 After-Tax Cash Flows

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Chapter 12

• calculates income taxes due or owed.
• discusses the incremental nature of income taxes.
• calculates combined federal and provincial income
  taxes.
• calculates after-tax cash flows.

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• calculates after-tax measures of merit (PW).
• evaluates alternatives on an after-tax basis.

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Income Taxes

• Taxes have an effect on cash flow and affect the
  investment decisions managers make.
• Integrating tax considerations into economic
  analysis requires a thorough understanding of two
  issues
• How the taxes are imposed.
• How taxes affect the economic analysis techniques.

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Calculation of Personal Taxable Income

• Federal income taxes due depend on taxable income
  and income tax rates
• Progressive individual federal income tax
  structure
• Gross Income Deductions Taxable income
• Gross income wages and salary, interest and
  dividend income, etc.

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• Deductions retirement plan contributions,
  business investment expenses, etc.
• Personal income tax rates vary across provinces
  and are progressive, with the exception of
  Alberta, which uses a flat rate.

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Calculation of Taxable Income

• Average tax rate Taxes payable/taxable income
• Marginal tax rate tax rate applicable to the
  next tax dollar

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• If the next dollar of income does not cause tax
  bracket creep, the marginal tax rate would
  equal the sum of the federal income tax rate
  provincial income tax rate
• If an individual was in 26 and 14 at the
  federal and provincial levels tax brackets
  respectively, the marginal tax rate would be 40.

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Corporate Income Taxes

• More complex than individual income taxes
• Credit terms, time lags
• Corporate accountants apply Generally Accepted
  Accounting Principles (GAAP) to capture reality
• Income Tax Act defines specific accounting
  concepts
• depreciation, cost base, book value, salvage value

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• Corporate taxes are not progressive they vary by
  business and province.
• In 2006, the federal rate on incomes gt 300,000
  was 22.1.
• It ranged from 8.9 in Quebec to 17 in
  Saskatchewan.

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Income Statement ABC Corporation 1999

• Operating revenues OR
• Operating costs -OC
• Before-tax cash flow BTCF
• CCA -CCA
• Debt interest -I
• Taxable income OR OC CCA - I
• Less income taxes (rate t) t(OR OC CCA -
  I)
• Net Profit (loss) OR OC CCA - I)(1 -
  t)

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Calculation of After-tax Figureof Merit 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 merit (PW,
  IRR, payback, etc.).

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Accounting and Engineering Economy

• Principal accounting statements
• Income statement what happened during last year
• Cash flow statement sources and uses of cash
• Operating revenue Operating cost BTCF
• BTCF Debt interest CCA Taxable income,
  where Taxable income BTCF - Debt interest CCA

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• Taxable income Net profit Income tax, where
  Net profit Taxable income Income tax
• Net profit Taxable income(1 - t)
• BTCF Before-tax cash flow

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Accounting and Engineering Economy After-Tax
Cash Flow

• ATCF Net profit CCA Debt interest
• Taxable income(1-t) CCA(t)
• BTCF - I CCA(1-t) CCA I
• BTCF(1-t) - I(1-t) CCA(1-t)
• CCA I
• OR - OC(1-t) I(t) CCA(t)

ATCF OR(1-t) - OC(1-t) I(t) CCA(t), where t
tax rate
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Income Statement
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Net Cash Flow From Operations (NCFO)

• NCFO ATCF I Dividends
• OR(1-t) OC(1-t) I(t) CCA(t)
• I - Dividends
• OR(1-t) OC(1-t) I(1-t)
• CCA(t) Dividends
• (1-t)OR-OC-I CCA(t)
• Dividends

NCFO Net Profit CCA - Dividends
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Net Cash Flow

• Net cash flow
• Net cash from operations New equity New debt
  Proceeds from asset disposal - Repurchase of
  equity - Repayment of debt (Principal) - Purchase
  of assets

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Net Cash Flow and Net Profit

• CCA deduction reduces taxable income but not the
  cash flow.
• Actual effect of CCA is to increase the tax flow
  by an amount tax rate x CCA.
• CCA is added to the net profit to get the net
  funds.

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Net Cash Flow Calculations
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Acquiring and Disposing ofAssets

• Acquisitions are added to asset pool and
  disposals are subtracted.
• Reconciliation to the cash flow requires
  calculation of net salvage value.
• From Canadian tax rules, a loss on disposal or
  recaptured CCA is allocated on an ongoing basis
  by the DB mechanism at the asset groups CCA rate
• known as books open

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• Applying recaptured CCA or losses to the income
  statement in the year of disposal is
• known as books closed

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Books Closed Assumption

• CCA recapture ? taxes payable
• Disposal loss ? tax credit

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• Net salvage value (NSV)
• S DTE S(1-t) tBd
• P original
• t marginal tax rate
• S Salvage value (before-tax proceeds from
  disposal)
• Bd Book value
• DTE disposal tax effect t(Bd S)
• NSV after-tax proceeds from disposal

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• A company with a marginal tax rate 40 is
  selling its production equipment (CCA rate 25)
  for 400,000. The original cost was 1 million
  and the book value is 600,000. Find the
  equipments net salvage value.

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• DTE t(B - S)
• 40( 600,000-400,000)
• 80,000
• NSV S DTE
• 400,000 80,000
• 480,000

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Acquiring and Disposing of Assets Capital Gain

• Capital Gain Selling price on disposal gt
  original cost
• Tax on capital gains 50
• Marginal Tax Rate
• Capital gains taxes are paid when realized

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• Land was purchased 5 years ago for 4 million.
  Its current market value is 7 million. The tax
  rate is 30.
• If the land were sold today (abstracting from
  selling expenses), the capital gains tax would be
  450,000 and the net salvage value 6.55
  million ( 7 - 0.45).

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Capital Tax Factors (CTF) and Books Open

• Values that capture the effect of future tax
  savings arising from the capital cost allowances
  (CCA) of a depreciable asset.
• Subtracting the value of these tax savings from
  the acquisition cost of the asset (P) gives the
  assets after-tax present worth.
• CTF for the acquisition cost (P) which is based
  on the half-year rule
• CTF 1 td/(id)(1(i/2))/(1i)

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• CSF for the disposal of an asset
• CSF 1 td/(id)
• t tax rate
• d CCA rate
• i interest rate

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CTF Problem

• A new truck has a current price tag of 100,000
  and is expected to generate a BTCF of 40,000
  annually for six years.
• Discount rate 10
• Disposal in 6 six years 10,000
• CCA rate 20
• Income tax rate 50,
• Find the trucks PW.

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• PW (first cost)
• -100,000(CTF)
• 1 0.5(0.2)/(0.100.2)(10.05)/(10.10)
• 0.6364
• The PW (first cost) -63,640

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• CSF 1 - (0.5)(0.2)/(0.10.2)
• 0.6667
• PW (disposal) 10,000(P/F,10,6)(CSF)
• 3,763

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• PW(annual cash flow)
• (30,000 )(1 - 0.5)(P/A,10,6)
• 65,325
• The after-tax PW
• -63,640 3,763 65,325
• 5,448

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Working Capital Requirements

• Time lags exist between money for expenses and
  money from sales.
• Working capital injection of money to cover
  time lags.
• Some situations require initial working capital
  only as cash receipts and expenses are
  essentially balanced afterwards.

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Problem Working Capital
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Example 12-11

• CTF
• 1-(0.4x0.25/(0.10.25))(1.05/1.1)
• 0.7273
• CSF
• 1-(0.4x0.25/(0.10.25)
• 0.7143

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• EUAW
• -(80,000x0.7273 55,000)(A/P,10,5)
• (167,000 - 79,000)(1-0.40)
  (5,000x0.7143 55,000)(A/F,10,5)
• -29,858 52,800 9,594
• 32,536

Compare with EUAW on next slide
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Working Capital
Example 12 - 11
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Loan Financing

• Money paid for the use of money is an expense of
  doing business
• The repayment of the loan principal must come
  from the after-tax cash flow

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Problem Working Capital
100,000 loan at 12 interest. Interest payable
annually. Loan repaid in 5 equal payments
20,000
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Loan Financing
Example 12 12
Disagreement with book calculations
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Estimating the After-tax ROR

• Interest on debt is tax-deductible
• After-tax cost of debt capital (idt) id(1-t)
• id before-tax cost of debt capital
• t marginal tax rate

There is no short-cut to computing the after-tax
rate of return on a project from its before-tax
rate of return (except when non-depreciable
assets and financing are repaid in a lump sum at
the end of the project.