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

EGR 403 Capital Allocation Theory

Dr. Phillip R. RosenkrantzIndustrial & Manufacturing Engineering Department

Cal Poly Pomona

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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

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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.

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A Partner(s) in the Business

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.

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

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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.).

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Calculation of Taxable Income

• Tax laws can be very complex leading to very complex calculations.

• A tax is just another disbursement for services rendered.

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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.

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Taxable Income of Business Firms

• Taxable income = gross income - operating expenses - depreciation

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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.

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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

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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

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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

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Figuring Personal Income TaxesGross 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.

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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

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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

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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