Ir. Haery Sihombing/IP
Sihombing/IP
Pensyarah Pelawat
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka
6
1.
Terminology and Rates
2.
Before and AfterAfter-Tax Analysis
3.
Taxes and Depreciation
4.
Depreciation Recapture and Capital Gains
5.
AfterAfter-Tax Analysis
6.
AfterAfter-tax Replacement
7.
ValueValue-added Analysis
TAX ECONOMIC ANALYSIS
Learning Objectives
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Gross Income:
Total income for the tax year from all
revenue producing function of the
enterprise.
„ Sales revenues
INCOME TAX TERMINOLOGY AND
RELATIONS FOR CORPORATIONS
AND INDIVIDUALS
„ Fees
„ Rent
„ Royalties
„ Sale
of assets
Important terms: Gross Income
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The total amount of money transferred
from the enterprise to the various taxing
agencies for a given tax year.
All legally recognized costs associated
with doing business for the tax year.
„ Real
Cash Flows
„ Tax deductible for corporations :
¾ 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.
¾ This tax is based upon the income producing
power of the firm.
„ Wages
and salaries
„ Utilities
„ Other
taxes
expenses
„ Material
„ Etc.
Operating Expenses (E)
Income Tax
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„
„
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:
„
Calculated amount of money for a
specified time period from which the tax
liability is determined.
Calculated as:
„ TI
= Gross Income – expenses –
depreciation
„ TI
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= GI – E – D
[1]
Taxable Income (TI)
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„ Taxes
= (taxable income) x (applicable rate)
= (TI)(T).
[2]
Tax Rate
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T
8
Net profits (if positive) represent funds
that are the claim of the owners of the
firm – NOT the firm!
„ NPAT can be:
„
„
Amount of money remaining each year
when income taxes are subtracted from
taxable income.
„
NPAT = TI – {(TI)(T)},
= (TI)(1(TI)(1-T).
„ “Saved”
Saved”
by the firm,
„ Reinvested within the firm,
„ Paid out as dividends to the stockholders,
„ Some combination of paying dividends and
reinvesting.
[3]
Net Profit After Tax (NPAT)
Net Profit After Tax (NPAT)
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Corporate Tax Rates:
Taxable Income
„ No
one single rate
„ Series of “graduated”
graduated” rates
„ TI is partitioned into up to 8 brackets of
taxable income
„ A tax rate is then applied to each bracket of
taxable income and then summed across all
applicable brackets.
Braket
1
2
3
4
5
6
7
8
Federal Corporate Tax Rates
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Braket Min
$0
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
Bracket Max
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
Sky's the limit!
The Eight Federal Tax Brackets (2002)
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Example:
Taxable Income
Braket Min
$0
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
Braket
1
2
3
4
5
6
7
8
T - (%)
„
Bracket Max Brkt. Rate
0.15
$50,000
0.25
$75,000
0.34
$100,000
0.39
$335,000
0.34
$10,000,000
0.35
$15,000,000
0.38
$18,333,333
0.35
Sky's the limit!
„
„ 1st
$50,000(0.15) = $7,500
„ Next $25,000(0.25) = $6,250
„ Next $25,000(0.34) = $8,500
„
„
„
Add the bracket tax amounts:
4.
5.
$56,250
2.
3.
$100,000(0.34) = $34,000.
$34,000.
1.
2.
3.
4.
5.
6.
8.
Tax as a % of TI:
¾
$56,250/$200,000 = 28.13%
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Each bracket rate is termed a “marginal”
marginal” rate.
Note the bracket rates are:
7.
„
($100,000 left)
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Total Tax on TI = $200,000
$7500
$6250
$8500
$34000
($125,000 left)
Now we are in the 44-th bracket
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1.
($150,000 left)
¾ Tax all monies between $100,000 to $335,000 at 34%
Bracket Tax Rates
„
Assume TI = $200,000.
Determine the Federal tax liability.
15%
25%
34%
39%
34%
35%
38%
35%
Observations
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„
„
„
„
The first $50,000 of TI is taxed at the bracket
rate of 15%.
Any additional TI over $50,000 flows into the
next bracket.
The next $25,000 or part thereof, is taxed at
the marginal bracket rate of 25%.
Each additional $ that moves a firm into a
higher bracket is taxed at the higher bracket’
bracket’s
tax rate.
„
„
„
A “tax bracket”
bracket” system is termed a “graduated
tax system”
system”.
Additional amounts of taxable income are
taxed at the associated bracket tax rate.
The max bracket rate is 39% and the
minimum bracket rate is 15%.
Marginal Tax Rates
Tax Bracket Description
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„
„
Firms with lower TI pay less taxes that firms
with much higher TI.
Arguments now for a “flat”
flat” tax rate.
„ Debate
„
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this point in class!
Most states have a state and local
corporate tax structure.
„ Firms have to pay:
„
„ Federal
For engineering economy studies:
„ The analyst will not know the exact TI for
the firm so,
„ Assume a flat rate which is normally 34%
for Federal Tax analysis (approximation).
corporate taxes and possibly,
„ State corporate taxes and even,
„ County or city income taxes.
„
If this is the case apply a combined tax
rate……
rate……
Observations
State and Federal
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„
Assume a know state tax rate then:
„
Compute:
„ Effective
„ Te
„
„
„
„
Tax rate – Te as:
= state rate + (1 – state rate)(Federal Rate)
„
State income taxes are deductible
expenses for federal income tax purposes.
„
Individuals report total income;
Gross earned income;
However, individuals may not deduct most of
their expenses for day to day living and
working.
Individuals must apply the various standard
or itemized deductions permitted by current
law
Corporations deduct actual cash flow
expenses.
Combined Tax Rate
Personal vs. Corporate
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„
„
„
Individual have to file as either:
„ Single,
„ Married,
„ Head of household.
Corporations have no such filing status other
than filing as a corporation
Similar bracket design with 5 brackets;
15%
2. 28%
3. 31%
4. 36%
5. 39.6%
1.
„
The bracket amounts depend upon filing
status: (Single, Married, Head of household).
Personal vs. Corporate
Individual Tax Rates
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„
NCF represents:
„ Cash
Inflow – Cash Outflows for a given time
period.
Fro economy studies the engineer will
estimate the future net cash flows associated
with the project over the estimated life of the
project.
„ Now, we define Cash Flow Before Tax (CFBT).
CFBT).
„
BEFORE-TAX AND AFTER-TAX
CASH FLOW
NET CASH FLOW - NCF
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„
„
CFBT:
CFBT =
„ Gross
income – expenses – initial
investment + salvage value
„ Actual
real cash flows associated with an
investment BEFORE any income tax
considerations are applied.
„ CFBT does not consider depreciation or
depletion amounts.
„
CFBT= GI – E – P + S
[7]
Note:
„ Depreciation
and depletions amounts are not
part of CFBT as they are not real cash flows per
se.
Cash Flows Before Tax ( CFBT )
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CFBT Defined
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„
CFAT for a given time period is defined as:
CFAT = CFBT – Taxes.
„ The
“Taxes”
Taxes” component must be expanded to
include the impacts of depreciation and or
depletion.
„ Depreciation is a noncash flow but is deductible
from GI and serves to moderate (lessen) the TI
amount.
Cash Flow After Tax ( CFAT)
„
Specifically:
CFAT = GI – E – P + S –(GI(GI-E-D)(TE)
„ Note the (GI(GI-E-D)(Te) term.
„ (GI – E – D) represent the taxable income
component;
„ Multiply (GI(GI-E-D) by Te computes the tax on
the taxable income part.
„ Then the tax is subtracted from the CFBT to
yield the CFAT amounts.
Expanding the CFAT Amount
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Focus on: (GI – E - D).
„ For some time periods this term could be
negative.
o Operating “loss”
loss” which can generate a
“negative”
negative” tax.
o If this is the case then “so be it”
it”.
o Let the sign take care of itself!
„
„
A tabular approach is suggested.
„
Numerous formats exist and no one
single format or design is “the best”
best”.
„
See Table and Example
„
Suggested tabular format follows.
Some Observations
CFBT: Format
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Life
Discount Rate
(Signed)
Time
Gross
Period
Income
0
1
$200,000
2
$200,000
3
$200,000
4
$200,000
5
$200,000
6
$200,000
$1,200,000
6
15.00%
(+)
Operating
Expenses
$90,000
$90,000
$90,000
$90,000
$90,000
$90,000
$540,000
(+) or (-)
Investment
or Salvage
-$550,000
$150,000
-$400,000
NPV Amt
IROR
Calculated
CFBT
-$550,000
$110,000
$110,000
$110,000
$110,000
$110,000
$260,000
$260,000
($68,857.76)
10.751%
Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$200,000
2
$200,000
3
$200,000
4
$200,000
5
$200,000
6
$200,000
$1,200,000
35.00% Discount Rate Atax
(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$550,000
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$150,000
$540,000
-$400,000
10.00%
(4)
Non-CF
Depreciation
Amt (+) values
$110,000
$176,000
$105,600
$63,360
$63,360
$31,680
$550,000
First four columns are presented…..
ATCF Format: Example
BTCF Format with Example
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(5)
Intermed. Cal.
Taxable
Income (TI)
(6)
(-) C.F
Taxes
(7)
Calculated CF
CFAT
$0
-$66,000
$4,400
$46,640
$46,640
$78,320
$0
-$23,100
$1,540
$16,324
$16,324
$27,412
$38,500
NPV
IROR
-$550,000
$110,000
$133,100
$108,460
$93,676
$93,676
$232,588
$221,500
-$5,075.14
9.708%
(7)
Calculated CF
CFAT
t
0
1
2
3
4
5
6
-$550,000
$110,000
$133,100
$108,460
$93,676
$93,676
$232,588
$221,500
t
0
1
2
3
4
5
6
These amounts represent
the after-tax cash flow
values for years 0 – 6.
The analyst can calculate
PW, FW, AW, IROR, etc
using the methods in the
previous chapters.
The Goal: Is this
investment acceptable?
Last four columns are presented…..
ATCF Amounts from Col 7.
Format: Example
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Best performed with a spreadsheet model
as shown.
„ Depreciation amounts can be calculated in
another spreadsheet and copied (values
only) into the ATCF worksheet.
„ User inputs besides the CF values are the
discount rate and the tax rate.
„
Effect on Taxes of Different
Depreciation Methods and
Recovery Periods
ATCF Calculations
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„
Given, two or more depreciation (recovery)
plans and:
„ Constant single value tax rate;
1.
2.
„ Same recovery period;
„ CFBT > depreciation amount for the given year;
„
n
„ The methods reduce the basis to the same book
PWtax
value over the same time period.
„
Minimize the present worth at some i% over n
time periods of the tax;
Maximize the present worth at some i% over
n time periods of the taxes saved.
PWTAX is defined by:
¦ (taxes in year t)(P/F,i%,t) or,
t 1
Compute the PW(i%) of the future tax
savings for each plan.
n
PWtaxes saved
¦ D (t )( P / F , i%, t )
t
e
t 1
Criteria for Selection
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Multiple Criteria can be used
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„
„
For depreciation plans over the same
recovery period and targeting the same
salvage value:
„ The total taxes saved are equal for all
depreciation models;
„ The present worth of taxes saved is always
less for accelerated depreciation methods.
If the firm is profitable and the TI amount
is > 0 then:
„ Using
a depreciation plan that writes off more
of the asset in the early years is preferred!
„ Achieve greater tax savings early on permits
the firm to retain more afterafter-tax dollars;
„ Which can be reinvested at or above the
firm’
firm’s MARR!
„ Promote future wealth maximization!
The Goal!
Rule:
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DEPRECIATION RECAPTURE
AND CAPITAL GAINS AND
LOSSES FOR CORPORATIONS
Comparing Depreciation Plans
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Firms sell or dispose of assets from time to
time.
„ Those assets have been fully depreciated or,
are still being depreciated for tax purposes.
„ Assets that are disposed do have a book
value.
„
be + or,
„ Could be “0”.
„
A capital loss occurs when an asset is sold
for less than it’
it’s current book value.
„
Could generate a tax savings since the
“loss”
loss” could be tax deductible within
certain rules.
„ Could
„
CL = BVt - SP
Capital Loss: CL
CAPITAL GAIN OR GAIN ON SALE
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„
Gain on Sale is defined as:
„ GS
„
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Confine discussion to the disposal of
productive assets.
„ The term “Depreciation Recapture”
applies. ( DR ).
„
= Selling Price – Current Book Value
Capital Gain is defined as:
„ CG
= Selling Price – First Cost.
Certain Assets will gain value over time and
could be sold for more than what was
originally paid for them.
„ This will generate a tax liability and tax will
have to be paid!
„
„
„
DR = SP – BVt
Three possible outcomes can happen
when a productive asset is disposed at
time t.
Sale of Productive Assets
Gain on Sale (Capital Gain)
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[12]
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1.
The asset is sold for a price > BVt
„
2.
SP = BVt no tax liability generated
The asset is sold for a price < BVt
„
„
SP > BVt generates a tax liability
The asset is sold for a price = BVt
„
3.
Assume an asset was originally purchased
for $10,000, 3 years ago.
„ Assume the current book value for tax
purposes is $3000.
$3000.
„ We will apply three different hypothetical
selling prices to see the various tax
implications due to disposal.
„ Assume a tax rate of 34% applies.
„
SP < BVt generates a tax savings
Assume a tax rate – Te applies.
Disposal Example
Disposal – 3 Outcomes
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Assume SP = $4,000.
„ BV = $3,000.
„ Compute (SP – BV) = (4,000 – 3000).
„ Equals +$1,000.
Depressiasion)
+$1,000. (Recaptured Depressiasion)
„ Gain on Disposal.
Disposal.
„ Tax Rule: Treated as ordinary income to
the firm and taxed at the tax rate.
„ Tax: $1000(0.34) = $340.00
„ NCFsale = $1000 – 340 = $660
„
Disposal: SP > BVtime of sale
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B
Current
Book
Value
SV = 0
Depreciated Portions from
which tax savings
Have resulted
Undepreciated Amount
(Investment remaining to be
Recovered)
RD Cases Illustrated
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B
Recaptured Depreciation
Remaining Book value
Sales Price > BV
SP > BV
Current
Book
Value
Amt. “over-depreciated:
Recaptured as Ordinary Income:
Taxed @ Ord. Tax Rate
SV = 0
RD Amt
RD: SP > BV@ Disposal
Assume SP = $3,000.
„ Compute (SP – BV) = (3000 – 3000) =0
„ No gain or loss on sale;
„ No tax implications!
„ NCFSale = $3,000.
„ When asset is disposed of for it’
it’s current
book value there is no recaptured
depreciation and no tax.
„
Disposal: SP = BVTime of Sale
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„
„
„
„
„
„
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Tax: ((-1000)(0.34) = -$340.00
„ Form of a negative tax!
„ NCF = SP – Tax;
„ NCF = $2,000 – (-340) = $2,340!
„ Treat the tax savings on the loss on
disposal as a positive cash flow.
„ Assume tax deductibility of the loss
amount which generates a tax savings.
„
Assume SP = $2,000;
BV = $3000
Compute: (SP – BV) = (2000 – 3000) =
¾ -$1,000.
¾ “Minus”
Minus” means “loss on disposal”
disposal”
The loss can be treated as a negative ordinary
income and deducted.
Tax: ((-1000)(0.34) = -$340.00
Form of a negative tax!
Disposal: SP = BVTime of Sale
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Disposal: SP < BVTime of Sale
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Asset is disposed at below the
book value creating a loss on
disposal.
B
Creates a “loss” on disposal and
is treated as a deduction—tax
savings.
Current
Book
Value
What if the SP is greater than the original
basis of the asset? (rare for productive assets)
„ Assume SP = $12,000;
„ B = $10,000.
„ BVtime of sale = $3,000
„ Two Components to deal with:
„
„ (SP
– B) = 12,000 – 10,000 = $2,000
„ Called the “Gain”
Gain” amount
Sale Price less than BV
SV = 0
Loss On
Disposal
RD: SP < BV@ Disposal
Disposal: 4th Situation: SP > B
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„
2nd Component:
„B
– BVTime of Sale
„ $10,000
„
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„
Tax the Recaptured Depreciation amount of
$7,000 at the ordinary income tax rate of
34%.
„
The RD amount is treated as ordinary income.
„
Possible Tax Evaluation assuming the “gain”
gain”
part is taxed at 28% and RD at 34%
- $3,000 = $7,000
Tax Situation for Economy Studies
„ Tax
the “gain”
gain” part at either 34% or,
whatever the current capital gain tax rate is
at the time (28%) on gains.
Disposal: 4th Situation: SP > B
Disposal: 4th Situation: SP > B
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„
Possible Tax Evaluation assuming the “gain”
gain”
part is taxed at 28% and RD at 34%
„ Total Tax:
„ SP
= $4000;
„ BV = $3000
Asset is sold for more than it’
it’s current
book value.
„ The depreciation plan specified that the
book value is now $3,000.
„ But a market value is now set at $4000.
„
„ Gain: $2000(0.28) = $560.
„ RD: $7000(0.34) =
Assume case 1:
„
$2380
$2940
„ NCF – sale: $12,000 - $2,940 = $9,060
„ (willing
buyer and willing seller agreement)
Recaptured Depreciation ( RD )
Disposal: 4th Situation: SP > B
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From the tax view:
„ The asset brought more that it’
it’s current
book value.
„ Implication: That the firm overover-depreciated
the asset by $1,000 (but not intentionally!)
„ The Tax code treats the $1000 as ordinary
income or, recaptured deprecation and
taxes it at 34%
„
To treat as ordinary income and pay a tax
on that amount.
„ Any time an asset is disposed of for an
amount that exceeds the current book
value for tax purposes,
„ The amount in excess of the current book
value is treated as ordinary income and
taxed as such.
„
To Recapture Means…
RD - Explained
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Under current Federal tax law:
Any depreciable asset that is disposed of during
the recovery period requires the following:
1. Only ½ year of the normal depreciation is permitted
in the year of disposal.
2. Assumption: Disposal occurs at the middle of the
year in question.
3. The beginning of year book value is reduced by the
½ year of recovery to establish the BV for tax
purposes.
Recall, MACRS assumes a “0” salvage
value for fully depreciated assets.
„ What if an asset is fully depreciated,?
„ Under MACRS the book value at the time
of disposal will be 0.
„ IF SP > 0 then the SP amount is also
taxed at the ordinary tax rate!
„
“0” Salvage Value Issue
Disposal During the Recovery Period
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„
„
„
„
„
Assume an asset is in it’
it’s 44-th year of recovery
and is sold (disposed).
Assume the beginning of year book value is
$5000.
Assume the 4th year’
year’s total recovery – if not
disposed – would be $2000.
Only ½ year of recovery is permitted for year 4
or ½(2000) = $1,000.
Disposal During Recovery Year
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Now, the book value for tax purposes is:
„ Beginning of year’
year’s BV3 = $5,000,
„ Less the $1,000 of permitted recovery due to the
halfhalf-year rule on disposal or, $4,000.
$4,000.
„
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The sale price, SP is now compared to the
$4,000 BV@ Time of Sale to determine if there
is any recaptured depreciation.
Disposal Example: Continued
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„
Assume disposal anytime during year “t”
where “t” is less than or equal to the
MACRS recovery period for the asset.
„
We now expand the TI expression to
accommodate depreciation recapture
amounts.
Mid-Year
Year”t”
No Depr. Permitted
E.O.Y.-t
B.O.Y.-t
However, the firm is eligible for ½ of the
Current year’s MACRS depreciation regardless
When disposal actually took place in the year.
Half-year Rule for Disposal
TI = GI – E – D +DR + CG – CL
[14]
Applicable only to corporations and not to individuals!
Depreciation Recapture Concluded
69
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70
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AFTER-TAX PRESENT WORTH,
ANNUAL WORTH, AND ROR
EVALUATION
Summary for Disposal Analysis
71
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72
Assuming the analyst has estimated all
relevant cash flows and conducted an
ATCF analysis the economic desirability of
the cash flow can be determined.
„ All techniques previously presented can be
used, e.g.,
„
„
„
„
„
Two or More Alternatives:
„
„ Select
the alternative with the largest PW or
AW value at the i% rate.
„ If using IROR, must apply the incremental
analysis approach.
Single Project or Multiple Alternatives
74
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All previous rules apply:
„
or AW > 0 at i% or,
„ IROR > i%.
73
Haery Sihombing
„
„ PW
Present Worth,
Future Worth,
Annual Worth,
IROR, . . .
After-tax Cash Flow Evaluation
„
Single Project:
„
For PW – equal lives
For AW – repeatability assumption applies
„
Some ATCF problems involve only costs.
„
Calculate the afterafter-tax savings generated
by operating expenses and depreciation
and attach a positive sign to the savings.
„
Some firms may set a beforebefore-tax discount
rate – MARRB.T..
„
For afterafter-tax analysis, the beforebefore-tax MARR
must be adjusted by applying:
„ MARRAfterAfter-Tax
„
= MARRBefore Tax(1(1-Te)
The BeforeBefore-tax MARR given the AfterAfter-tax
MARR is:
„ MARRBefore Tax
Analysis Techniques
After-tax Discount Rate
75
Haery Sihombing
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= (MARR
(MARRAfter Tax)/(1)/(1-Te)
Haery Sihombing
76
Given two or more ATCF alternatives:
„ Rank based upon time t = 0 investment;
„ Perform the pairpair-wise analysis to determine
a current champion;
„ Complete the pairpair-wise analysis until all
alternative have been evaluated.
„ Can perform a breakeven analysis by
plotting PW vs. i
„
All previously described analysis methods
can apply to the evaluation of an afterafter-tax
cash flow.
„ Unlike previous chapters, where the cash
flow was provided, one must first
construct the ATCF from a problem
specification – then apply the analysis
approaches.
„
Mutually Exclusive ATCF Analysis:
IROR
Bottom Line
77
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78
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„
Two ATCF alternatives;
„
Incremental RoR method is presented;
„
A plot of the two methods for discount
rates varying from 5% to 9% is also
SPREADSHEET APPLICATIONS
– AFTER-TAX INCREMENTAL
ROR ANALYSIS
shown;
Example :
80
79
Haery Sihombing
HAERY SIHOMBING
„
A breakeven interest rate equal to 6.35%
is determined;
„
The two alternatives are identical at
6.35% afterafter-tax MARR.
Example :
81
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82
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The interest rate
at
Which the two
Alternatives are
Economically
Equal (6.36%)
Breakeven Point
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HAERY SIHOMBING
83
Example Disposal Concerns
Haery Sihombing
84
Always beware of using the ROR method
for selecting from among alternatives.
„ DO NOT use computed ROR!
„
„ This
means the ROR computed on each
separate investment alternative.
„ Rather, form the incremental cash flow and
make a determination on the 'i* value.
„
AFTER-TAX REPLACEMENT
STUDY
Need to design a spreadsheet model to
effectively evaluate.
Using ROR for ATCF Analysis
85
86
Haery Sihombing
Replacement: After-Tax
„
„
Defender Asset
„ Asset
currently in service;
„ May be tax implications by disposing of the
defender (recaptured depreciation).
„ The current book value of the defender is
needed.
Review Chapter 11:
„ This
chapter did not consider taxes in the
analysis.
analysis.
To properly evaluate a replacement
type problem, on should always use an
afterafter-tax approach.
„ Elements such as:
„
„
Challenger Asset
„ The
asset that might be purchased or leased
to replace the defender.
„ Depreciation
and disposal with possible
recaptured depreciation can make a
difference in the analysis.
Replacement Basics
87
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Haery Sihombing
88
„
„
Elements than can alter the ATCF vs. a
BTCF analysis for replacement.
Defender:
„ Purchased
3 years ago for $600,000.
„ Now, outdated due to advancing
technology.
„ Assume classical straight line has been
applied (In reality, MACRS would be
applied).
„ Depreciation
and the tax savings.
„ Disposal implications of the defender.
„ Recaptured
Depreciation or,
on Disposal
„ HalfHalf-year convention for disposal during the life
of the defender if it is not fully recovered.
„ Loss
„ Assume
a 88-year recovery life applies.
„ Annual
Operating Costs: $100,000/year
„ Worth $400,000 now!
Building a Model for Replacement
ATCF Analysis: Example
89
Haery Sihombing
„
First Cost: $1,000,000
„
„ Assume
straight line depreciation with a 5 year
life – if purchased.
„ Annual Operating costs: $15,000/year.
„ Assume a “0” salvage value at the end of 5
years.
„
90
Haery Sihombing
Other Parameters:
„ BT discount rate: 10%
Assume further that a ESL analysis has
been conducted and the following
information is available:
„ For
the Defender: ESL from now is 5 more
years.
„ For the Challenger: ESL is 5 years.
„ Assume a “0” salvage value for both
alternatives applies.
„ AT discount rate: 7%
„ Effective tax rate: 34%
Challenger Asset
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Economic Service Life analysis
91
92
Haery Sihombing
Def.
Age
3
4
5
6
7
8
Life
Discount Rate
(Signed)
Time
Gross
Period
Income
0
1
2
3
4
5
$0
5
10.00%
(+)
Operating
Expenses
$100,000
$100,000
$100,000
$100,000
$100,000
$500,000
(+) or (-)
Investment
or Salvage
-$400,000
$0
-$400,000
NPV Amt
IROR
A. Worth
Calculated
CFBT
-$400,000
-$100,000
-$100,000
-$100,000
-$100,000
-$100,000
-$900,000
-779,079
#NUM!
-205,519
First 5 columns of the ATCF Worksheet:
Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$0
2
$0
3
$0
4
$0
5
$0
$0
34.00% Discount Rate Atax
(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$400,000
$100,000
$0
$100,000
$0
$100,000
$0
$100,000
$0
$100,000
$0
$500,000
-$400,000
7.00%
(4)
Non-CF
Depreciation
Amt (+) values
$75,000
$75,000
$75,000
$75,000
$75,000
$375,000
(5)
Intermed. Cal.
Taxable
Income (TI)
-$175,000
-$175,000
-$175,000
-$175,000
-$175,000
Before-Tax Cash Flow Analysis for Defender
A. Cost to Retain: $205,519/year for 5 years at 10%.
ATCF: Defender Asset
BTCF – Defender if Retained 5 years
93
Haery Sihombing
(6)
(-) C.F
Taxes
-$59,500
-$59,500
-$59,500
-$59,500
-$59,500
-$297,500
NPV
IROR
Ann Worth
94
Haery Sihombing
(7)
Calculated CF
CFAT
-$400,000
-$40,500
-$40,500
-$40,500
-$40,500
-$40,500
-$602,500
-$566,058.00
#NUM!
-$138,056
First five columns of the ATCF worksheet for Challenger
t
0
1
2
3
4
5
Ann. Cost
to retain
the
defender
– Aftertax
analysis.
Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$0
2
$0
3
$0
4
$0
5
$0
$0
$200,000
$200,000
$200,000
$200,000
$200,000
$1,000,000
(5)
Intermed. Cal.
Taxable
Income (TI)
$25,000
-$215,000
-$215,000
-$215,000
-$215,000
-$215,000
Challenger: After-Tax
95
HAERY SIHOMBING
7.00%
(4)
Non-CF
Depreciation
Amt (+) values
Depr. Recapture on defender trade in
Last Columns: ATCF Retain Defender
Haery Sihombing
34.00% Discount Rate Atax
(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$1,000,000
$15,000
$0
$15,000
$0
$15,000
$0
$15,000
$0
$15,000
$0
$75,000
-$1,000,000
96
Haery Sihombing
„
Defender’
Defender’s book value at the end of year 3:
„ $600,000
„
– 3($75,000) = $375,000.
$375,000.
Assume Defender is sold for $400,000.
„ SP
> BV at time of sale;
„ Compute: (SP – BV);
„ (400,000 – 375,000) = +25,000.
„ Treated as Ordinary Income
„ Tax: ($25,000)(0.34) = $8,500.
Defender Recaptured Depreciation
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Haery Sihombing
If the defender were retained, then no tax
liability (no recaptured depreciation).
„ If the decision to replace is made,
ordinary income amount of $25,000 (gain
on sale) is assigned to the challenger!
„ Because going with the challenger would
trigger the recaptured depreciation
amount.
„
Tax on Recaptured Depreciation
98
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(6)
(-) C.F
Taxes
(7)
Calculated CF
CFAT
$8,500
-$73,100
-$73,100
-$73,100
-$73,100
-$73,100
-$365,500
NPV
IROR
Ann Worth
-$1,008,500
$58,100
$58,100
$58,100
$58,100
$58,100
-$718,000
-$770,278.53
#NUM!
-$187,864
• If Defender is retained:
t
0
1
2
3
4
5
Annual cost if
The challenger
Is
Purchased
Is $187,864/yr.
•BTCF annual cost:
$205,520/year
•ATCF annual cost:
$138,056/year
• If the Challenger is purchased:
•BTCF annual cost:
$278,800/year
•ATCF annual cost:
$187,864/year
Retain Defender for 5 more years: Reevaluate in one
year if the estimates change.
Challenger ATCF – if purchased.
Example Summary
99
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100
„
The last example specified straight line
recovery;
„
Typically, MACRS would be used;
„
For the defender, only a ½ year of recovery
would be permitted.
„
Thus, all ATCF values would be different
than what has been shown.
AFTER-TAX VALUE
ADDED ANALYSIS
Technical Note
101
102
Haery Sihombing
Value added is a term to indicate
that a product or a service:
„
„
„ Has
added value to the consumer or buyer.
„ Popular concept in Europe;
„ ValueValue-added taxes are imposed in Europe on
certain products and paid to the government.
„
„
„
„
You go and buy onions at a market;
Pay from 25 to 50 cents a pound for the onions;
You like onion rings so:
Onion rings require that onions be purchased,
chopped, and fried;
You buy onion rings for say $1.78/pound;
Much higher that raw onions!
VALUE ADDED: Example
VALUE ADDED
103
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104
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Why do you pay $1.78/pound for onion
rings and only say 30 cents a pound for raw
onions?
„ Because of the processing costs associated
with transforming raw onions into onion
rings!
„ Value (cost) is added due to the processing
costs and different packaging.
„
„
Rule:
„ The decision concerning an economic
alternative will be the same for a value
added analysis and a CFAT analysis.
„ Because, the AW of economic value
added estimates is the same as the AW
and CFAT estimates!
VALUE ADDED
VALUE ADDED: Example
105
106
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To start, Apply Eq. 3:
„ NPAT = Taxable Income – taxes
„ NPAT = (TI)(1(TI)(1-T)
„ Value added or Economic Value Added ( EVA)
is:
„
„ The
amount of NPAT remaining after removing
the cost of invested capital during the time
period in question.
EVA indicates the project’
project’s contribution to
the net profit of the corporation after taxes
have been paid.
„ The cost of invested capital is normally the
firm’
firm’s afterafter-tax required MARR value.
„ One multiplies the ATAT-MARR by the current
level of capital (investment).
„ Charge interest on the unrecovered capital
investment at the ATAT-MARR rate.
„
VALUE ADDED: Starting Point
EVA - Explained
107
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108
„
Recall, firms often have two sets of books
relating to depreciation:
for tax purposes and,
„ One for internal management use. (book
depreciation).
„ For EVA, book depreciation is more often
used.
used.
„
„
Two Alternatives, A and B
A
Which alternative
is preferred using EVA?
„4
year life
„ P = -$500,000 with a “0” salvage value
„ GI – E = $170,000/yr
„ One
B
„
„4
year life
„ P = $1,200,000 with “0” salvage value
„ GI – E = {$600,000 decreasing by $50,000/yr}
„ More
closely represent the true rate of usage of
the assets in question.
EVA and Invested Capital
MARR = 12% (A.T), n = 4, Te = 40%
EVA – Example
109
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Plan A
n=
MARR =
Tax Rate
End of
Period
0
1
2
3
4
Sums
4
12.0%
40.0%
Plan B
End of
Period
0
1
2
3
4
Sums
(1)
GI Exp
$170,000
$170,000
$170,000
$170,000
$680,000
(1)
GI Exp
(2)
(3)
(4)
Investment Depreciation
Book
P
Value
-$1,200,000
$1,200,000
$600,000
$300,000
$900,000
$500,000
$300,000
$600,000
$400,000
$300,000
$300,000
$300,000
$300,000
$0
$1,800,000 -$1,200,000 $1,200,000
111
HAERY SIHOMBING
(4)
Book
Value
$500,000
$375,000
$250,000
$125,000
$0
(5)
Taxable
Income
$45,000
$45,000
$45,000
$45,000
$180,000
(5)
Taxable
Income
$300,000
$200,000
$100,000
$0
$600,000
(6)
Taxes
Owed
$0
$18,000
$18,000
$18,000
$18,000
$72,000
(6)
Taxes
Owed
$0
$120,000
$80,000
$40,000
$0
$240,000
(7)
Net Profit
After Tax
$0
$27,000
$27,000
$27,000
$27,000
$108,000
(7)
Net Profit
After Tax
$0
$180,000
$120,000
$60,000
$0
$360,000
Base Calculations: Plan A and B
Example Spreadsheet Model
Haery Sihombing
(2)
(3)
Investment Depreciation
P
-$500,000
$125,000
$125,000
$125,000
$125,000
-$500,000
$500,000
110
112
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(8)
Cost of
Invest. Capital
(9)
EVA
NPAT-CoIC
$0
-$33,000
-$18,000
-$3,000
$12,000
-$42,000
-$38,323
-$12,617
$60,000
$45,000
$30,000
$15,000
$150,000
PW of EVA
AW of EVA
(10)
t
0
1
2
3
4
PW
RoR
AW
(8)
Cost of
Invest. Capital
CFAT
-$500,000
$152,000
$152,000
$152,000
$152,000
$108,000
-$38,323
8.31%
-$12,617
$144,000
$108,000
$72,000
$36,000
$360,000
PW of EVA
AW of EVA
EVA Components EVA-CFAT for A
113
Haery Sihombing
(9)
EVA
NPAT-CoIC
$0
-$33,000
-$18,000
-$3,000
$12,000
-$42,000
-$38,323
-$12,617
(9)
EVA
NPAT-CoIC
$0
$36,000
$12,000
-$12,000
-$36,000
$0
$10,289
$3,388
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$1,200,000
$480,000
$420,000
$360,000
$300,000
$360,000
$10,289
12.44%
$3,388
EVA Components EVA-CFAT for B
114
Haery Sihombing
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$500,000
$152,000
$152,000
$152,000
$152,000
$108,000
-$38,323
8.31%
-$12,617
EVA-CFAT: A
(9)
EVA
NPAT-CoIC
$0
$36,000
$12,000
-$12,000
-$36,000
$0
$10,289
$3,388
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$1,200,000
$480,000
$420,000
$360,000
$300,000
$360,000
$10,289
12.44%
$3,388
Summary Values for A
PW of EVA
AW of EVA
-$38,323
-$12,617
PW
RoR
AW
-$38,323
8.31%
-$12,617
Summary Values for B
PW of EVA
AW of EVA
EVA-CFAT: B
$10,289
$3,388
PW
RoR
AW
$10,289
12.44%
$3,388
“B” is the preferred option!
EVA and CFAT for A and B
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EVA Comparisons: A vs. B
115
116
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Note, the AW(12%) of the EVA and the
CFAT is the same.
„ Although the values that make up the
EVA column and the values that make
up the CFAT are different,
„ Their annual worth’
worth’s at 12% are identical.
„
„
„
„
„
EVA values represent an alternative’
alternative’s periodic
contribution to the value of the corporation or
firm:
The CFAT values represent the actual cash
flows – after tax –into the corporation or firm.
Corporate executives generally prefer to view
the EVA values;
Engineers will tend to compute the CFAT
values.
What does EVA Mean?
Meaning of EVA and CFAT
117
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„
118
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For the $500,000 investment in A the
capital recovery amount is:
For both options, a time t = 0 depreciable
investment is required.
„ This investment is recovered over 4 years
(written off for tax purposes).
„ There remains an unrecovered investment
at the beginning of each year.
„ The owner’
owner’s for the firm expect to earn
interest on the unrecovered investment.
„
„ $500,000(A/P,12%,4)
= $164,617/year over 4
years with a “0” salvage value assumed.
„ This amount is “charged”
charged” against the cash
inflows for each year for alternative A.
A Second Point To Consider
EVA and Capital Recovery
119
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120
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„
For EVA, the undepreciated investment at
the beginning of a time period is multiplied
by the MARR.
„ This calculates interest on the
undepreciated (unrecovered) investment.
„ These amounts are treated as a cost and
charged against the income flows.
„
„
AW of EVA and,
AW of CFAT:
„ Are identical in amount.
„ Either method can be applied.
applied.
EVA describes added worth or value to
the firm for the project;
„ CFAT describes the timing (how) the
funds will flow into the corporation.
„
Undepreciated (unrecovered) Investment
EVA vs. CFAT
121
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AfterAfter-tax analysis does not usually change
the decision to select one alternative over
another.
„ ATCF does offer a much clearer estimate of
the monetary impact of taxes.
„ AfterAfter-tax PW AW, and ROR evaluations of
one or more alternatives are performed on
the CFAT series: using exactly the same
procedures as n previous chapters.
„
TheThe-afterafter-tax MARR is used in all PW
and AW computations, and in deciding
between two or more alternatives using
incremental RoR analysis.
„ Generally the firm will apply two interest
rates:
„
„ MARR
value for beforebefore-tax analysis;
„ MARR value for afterafter-tax analysis.
Summary
Summary
123
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122
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124
Income tax rates for U.S. corporations and
individual taxpayers are graduatedgraduated-higher
taxable incomes pay higher income taxes.
„ A singlesingle-value, effective tax rate Te is usually
applied in an afterafter-tax economic analysis.
„ Taxes are reduced because of taxtax-deductible
items:
„
„ depreciation
and,
„ operating expenses.
expenses.
„
In computing taxable income, permissible
nonnon-cash flow amounts can be applied to
moderate TI:
„ Depreciation
amounts,
„ Depletion amounts,
„ Amortization amounts.
„
For CFAT analysis, depreciation and
depletions amounts must be considered as
part of the analysis.
Summary
Summary
125
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126
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Taxable Income (TI):
TI = gross income - expenses - depreciation
+ depreciation recapture
„ If an alternative's estimated
contribution to corporate financial
worth is the economic measure:
the economic value added (EVA) should be
determined. Unlike CFAT, the EVA
includes the effect of depreciation.
„
„
Key general cash flow afterafter-tax
relations for each year are:
„ CFBT = gross income - expenses - initial
investment + salvage value .
„ CFAT = CFBT - taxes = CFBT - (taxable
income)(Te).
Summary
Summary
127
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128
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Economic Value Added is:
„
„
„
„
EVA = net profit after taxes - cost of invested
capital
= NPAT - (after(after-tax MARR)(book value) = TITItaxes - i(BV)
The equivalent annual worths of CFAT and EVA
estimates are the same numerically, due to the
fact that they interpret the annual cost of the
capital investment in different, but equivalent
manners.
„
Economic Value Added is:
„ EVA = net profit after taxes - cost of
invested capital.
„ EVA =
„ NPAT
- (after(after-tax MARR)(book value)
„ NPAT = TI - taxes - i(BV)
„ EVA analysis is often preferred by
corporate executives as opposed to CFAT.
Summary
Summary
129
Haery Sihombing
In a replacement study,
study, the tax impact of:
„ depreciation
130
Haery Sihombing
recapture or
„ capital
loss,
loss,
„ either of which may occur when:
„ the defender is traded for the challenger and,
„ Must be accounted for in an afterafter-tax analysis.
The tax analysis may or may not reverse
the decision to replace or retain the
defender:
But the effect of taxes will likely
reduce (possibly by a significant
amount) the economic advantage of
one alternative over the other.
Summary
Summary
131
Haery Sihombing
HAERY SIHOMBING
132
Haery Sihombing
End
133
HAERY SIHOMBING