Chapter 11
Corporate Income Taxes
• Income tax rates
• Average vs.
Marginal tax rates
• Gains taxes
• Income tax rate for
economic analysis
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Economics
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Corporate Income Taxes
(Year 2000)
(dollars in millions)
Company
Gross
Income
Taxable
Income
Intel
$33,726
$15,141
Cisco
18,920
Amazon
Broadcom
Oracle
Income
Taxes
Net
Income
Average
Tax Rate
$4,606
$10,535
30.42%
4,343
1,675
2,668
38.57%
2,762
(1,707)
0
(1,411)
0%
1,132
339
68
271
20.00%
17,173
101,232
3,827
6,297
37.80%
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Taxable Income and Income Taxes
Item
Gross Income
Expenses
Cost of goods sold (revenues)
Depreciation
Operating expenses
Taxable income
Income taxes
Net income
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Example 11.1- Net Income Calculation
Item
Gross income (revenue)
Expenses
Cost of goods sold
Depreciation
Operating expenses
Taxable income
Taxes (40%)
Net income
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Amount
$50,000
20,000
4,000
6,000
20,000
8,000
$12,000
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Capital Expenditure versus Depreciation
Expenses
0
$28,000
0
1
2
3
4
5
6
7
8
4
7
6
7
8
Capital expenditure
(actual cash flow)
1
2
3
$1,250
$4,000
$4,900
$6,850
$3,500 $2,500
$2,500 $2,500
Allowed depreciation expenses (not cash flow)
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Cash Flow vs. Net Income
Net income: Net income is an accounting means of
measuring a firm’s profitability based
on the matching concept. Costs become
expenses as they are matched against
revenue. The actual timing of cash inflows
and outflows are ignored.
Cash flow: Given the time value of money, it is better
to receive cash now than later, because cash
can be invested to earn more money. So,
it is desirable why cash flows are relevant
data to use in project evaluation.
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Why Do We Use Cash Flow in Project
Evaluation?
Example: Both companies (A & B) have the same amount of
net income and cash sum over 2 years, but Company A returns
$1 million cash yearly, while Company B returns $2 million
at the end of 2nd year. Company A can invest $1 million in year
1, while Company B has nothing to invest during the same period.
Company A
Company B
Year 1
Net income
Cash flow
$1,000,000
1,000,000
$1,000,000
0
Year 2
Net income
Cash flow
1,000,000
1,000,000
1,000,000
2,000,000
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Example 11.2 – Cash Flow versus Net Income
Item
Income
Cash Flow
Gross income (revenue
Expenses
Cost of goods sold
Depreciation
Operating expenses
Taxable income
Taxes (40%)
$50,000
$50,000
20,000
4,000
6,000
20,000
8,000
-20,000
Net income
$12,000
Net cash flow
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-6,000
-8,000
$16,000
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Net income versus net cash flow
Net cash flows = Net income + non-cash expense (depreciation)
$50,000
$40,000
$30,000
$20,000
$10,000
Net
cash flow
Net income
$12,000
Depreciation
$4,000
Income taxes
$8,000
Operating expenses
Cost of goods sold
$6,000
Gross
revenue
$20,000
$0
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U.S. Corporate Tax Rate (2001)
Taxable income
Tax rate
0-$50,000
15%
$50,001-$75,000
25%
$75,001-$100,000
34%
$100,001-$335,000
39%
$335,001-$10,000,000
34%
$10,000,001-$15,000,000 35%
$15,000,001-$18,333,333 38%
$18,333,334 and Up
35%
Tax computation
$0 + 0.15(D)
$7,500 + 0.25 (D)
$13,750 + 0.34(D)
$22,250 + 0.39 (D)
$113,900 + 0.34 (D)
$3,400,000 + 0.35 (D)
$5,150,000 + 0.38 (D)
$6,416,666 + 0.35 (D)
(D) denotes the taxable income in excess of the lower bound of
each tax bracket
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Marginal and Effective (Average) Tax Rate
for a Taxable Income of $16,000,000
Average tax rate =
Taxable income
$5,530,000
 34.56%
$16,000,000
Marginal Tax Amount of Taxes
Rate
Cumulative
Taxes
First $50,000
15%
$7,500
$7,500
Next $25,000
25%
6,250
13,750
Next $25,000
34%
8,500
22,250
Next $235,000
39%
91,650
113,900
Next $9,665,000
34%
3,286,100
3,400,000
Next $5,000,000
35%
1,750,000
5,150,000
Remaining
$1,000,000
38%
380,000
$5,530,000
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Example 11.3 - Corporate Income Taxes
Facts:
Capital expenditure
(allowed depreciation)
Gross Sales revenue
Expenses:
Cost of goods sold
Depreciation
Leasing warehouse
$100,000
$58,000
$1,250,000
$840,000
$58,000
$20,000
Question: Taxable income?
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Economics
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Taxable income:
Gross income
- Expenses:
(cost of goods sold)
(depreciation)
(leasing expense)
Taxable income
• Income taxes:
First $50,000 @ 15%
$25,000 @ 25%
$25,000 @ 34%
$232,000 @ 39%
Total taxes
$1,250,000
$840,000
$58,000
$20,000
$332,000
$7,500
$6,250
$8,500
$90,480
$112,730
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• Average tax rate:
Total taxes =
$112,730
Taxable income = $332,000
$112,730
Average tax rate =
$332,000
 33.95%
• Marginal tax rate:
Tax rate that is applied to the last dollar
earned
39%
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Disposal of Depreciable Asset
• If
a MACRS asset is disposed of during the
recovery period,
• Personal property: the half-year convention
is applied to depreciation amount for the year
of disposal.
• Real property: the mid-month convention is
applied to the month of disposal.
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Disposal of a MACRS Property and Its
Effect on Depreciation Allowances
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Depreciation recapture
Depreciation recapture is taxed as ordinary income.
Gains = Salvage value – book value
= (Salvage value - cost basis)
Capital gains
+ (Cost basis – book value)
Ordinary gains
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Capital Gains and Ordinary
Gains
Capital gains
Total gains
Ordinary gains
or
depreciation recapture
Cost basis
Book value
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Salvage value
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Gains or Losses on Depreciable Asset
Example 11.5: A Drill press: $230,000
Project year: 3 years
MACRS:
7-year property class
Salvage value: $150,000 at the end of Year 3
Full
Full
Half
8.92
8.92
14.29 24.49 17.49 12.49
8.92
Total Dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308
Book Value = 230,000 -109,308 = $120,693
Gains = Salvage Value - Book Value = $150,000 - $120,693
= $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035
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Calculation of Gains or Losses on
MACRS Property
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How to Determine Income Tax Rate to
be Used in Economic Analysis?
Revenues
Expenses
Taxable Income
Income Taxes
Regular
Project
Business
$200,000 $40,000
$130,000 $20,000
$70,000 $20,000
$12,500
?
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Economics
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Incremental Income Tax Rate
Gross revenue
Expenses
Taxable income
Income taxes
Average tax rate
Before
After
Undertaking Undertaking
Project
Project
$200,000
$240,000
130,000
150,000
$70,000
$90,000
$12,500
$18,850
17.86%
20.94%
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The Effect
of Project
$40,000
20,000
$20,000
$6,350
31.75%
22
0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%
Taxable income
Income taxes
Average tax rate
Before
After
Incremental
$70,000
$90,000
$20,000
12,500
18,850
6,350
17.86%
20.94%
Incremental tax rate
31.75%
$20,000 incremental
taxable income due to
undertaking project
Regular income from operation
$5,000
at 25%
Marginal tax rate
15%
$20,000
$0
25%
$40,000
$60,000
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$15,000
at 34%
34%
$80,000
$100,000
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Summary
• Explicit consideration of taxes is a necessary
aspect of any complete economic study of an
investment project.
• Once we understand that depreciation has a
significant influence on the income and cash
position of a firm, we will be able to appreciate
fully the importance of utilizing depreciation as a
means to maximize the value both of engineering
projects and of the organization as a whole.
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• For corporations, the U.S. tax system has the
following characteristics:
1. Tax rates are progressive: The more you
earn, the more you pay.
2. Tax rates increase in stair-step fashion:
four brackets for corporations and two
additional surtax brackets, giving a total
of six brackets.
3. Allowable exemptions and deductions
may reduce the overall tax assessment.
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• Marginal tax rate is the rate applied to the last
dollar of income earned;
• Average (effective) tax rate is the ratio of income
tax paid to net income; and
• Incremental tax rate is the average rate applied to
the incremental income generated by a new
investment project.
• Capital gains are currently taxed as ordinary
income, and the maximum rate is capped at 35%.
• Capital losses are deducted from capital gains; net
remaining losses may be carried backward and
forward for consideration in years other than the
current tax year.
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• An investment tax credit is a direct reduction of
income taxes payable, arising from the acquisition of
depreciable assets. Government uses the investment
tax credit to stimulate investments in specific assets or
in specific industries.
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