Engineering Economic Analysis
Canadian Edition
Chapter 12:
After-Tax Cash Flows
Chapter 12 …
Shows how to calculate income taxes.
Discusses incremental income taxes.
Determines combined federal and
provincial income tax rates.
Calculates after-tax cash flows.
Determines after-tax performance
measures, e.g. NPV, EACF, IRR, NFV,
PBP, and BCR.
Evaluates projects on an after-tax basis
with acquisition & disposal of assets.
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12-2
Income Taxes
 Taxes have an effect on cash flows and on
the investment decisions managers make.
 Integrating tax considerations into economic
analysis requires a thorough understanding of
two issues:
• how the taxes are imposed; and
• how taxes affect economic analysis techniques.
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12-3
Income Taxes …
 Federal income taxes are determined from
taxable income and income tax rates.
• Progressive individual federal income tax structure
 Gross Income – Deductions = Taxable
income.
• Gross income: wages, salary, interest income,
dividend income, etc.
• Deductions: retirement plan contributions,
business investment expenses, etc.
 Personal income tax rates vary across
provinces and are progressive; the exception
is Alberta which uses a flat rate.
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12-4
Income Taxes …
 Average tax rate = Taxes payable/taxable
income.
 Marginal tax rate— the tax rate that applies to
the next dollar of income earned.
 If the next dollar of income does not cause
the tax to advance to the next level, i.e.
“bracket creep”, the marginal tax rate equals
the sum of the federal income tax rate +
provincial income tax rate.
• An individual at the 26% federal tax level and the
12.29% provincial tax level has a marginal tax rate
of 38.29% (about $85,000 taxable income in B.C.).
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12-5
Corporate Income Taxes
 More complex than individual income taxes.
• Accountants apply Generally Accepted Accounting
Principles (GAAP).
 The Income Tax Act defines specific
accounting concepts:
• Depreciation/amortization, cost base, book value,
salvage value.
 Combined federal and provincial corporate
tax rates for British Columbia in 2009 were:
• 14.5% for small business income up to $400,000;
• 30% for Canadian-controlled private corporations
(CCPCs) with income over $400,000.
EECE 450 — Engineering Economics
12-6
Corporate Income Taxes …
Income Statement
for TMU Corporation
for the year ending December 31, 2008
Operating revenues
Less: Operating costs
Before-tax cash flow (BTCF)
CCA
Debt interest
Taxable income
Less: income taxes (rate T)
Net Profit (loss)
EECE 450 — Engineering Economics
OR
OC
OR  OC
CCA
I
OR  OC  CCA  I
T(OR  OC  CCA  I)
(OROCCCAI)(1T)
12-7
Accounting & Engineering Economy
 Understand the tax laws affecting the project
of interest.
 Estimate the cash flows without considering
the effects of taxes.
 Adjust the cash flows based on the effects of
depreciation and income taxes.
 Determine the after-tax measure(s) of merit
(NPV, IRR, etc.).
EECE 450 — Engineering Economics
12-8
Accounting & Eng’g Economy …
 Principal accounting statements:
• Balance sheet: financial position at end of year.
• Income statement: earnings during one year.
• Cash flow statement: sources and uses of cash.
 Key amounts from the income statement:
• Operating revenue = Operating cost + BTCF
(before-tax cash flow)
• BTCF = Debt interest + CCA + Taxable income
• Taxable income = BTCF  Debt interest  CCA
• Taxable income = Net profit + Income tax
• Net profit = Taxable income  Income tax
• Net profit = (Taxable income)(1  T)
EECE 450 — Engineering Economics
12-9
Accounting & Eng’g Economy …
 After-tax cash flow (ATCF):
= Net profit + CCA + Debt interest (I)
= (Taxable income)(1T) + CCA + I
= (BTCF  I  CCA)(1 T) + CCA + I
= (OR  OC)(1 T) + I(T) + CCA(T)
 Net cash flow from operations:
= ATCF – I – Dividends (DIV)
= (OR  OC)(1T) + I(T) + CCA(T)  I  DIV
= (OR  OC  I)(1T) + CCA(T)  DIV
= Net profit + CCA  DIV
EECE 450 — Engineering Economics
12-10
Accounting & Eng’g Economy …
 Net cash flow =
Net cash flow from operations
+ New equity issued
+ New debt issued
+ Proceeds from asset disposal
 Repurchase of equity
 Repayment of debt principal
 Purchase of assets
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12-11
Accounting & Eng’g Economy …
 The CCA (depreciation) expense reduces the
taxable income but it increases the cash flow.
 The CCA increases the cash flow by an
amount = TCCA, called the CCA tax shield.
 The CCA is added to the net income to get
the net after-tax cash flow.
EECE 450 — Engineering Economics
12-12
Accounting & Eng’g Economy …
 Acquiring and disposing of assets:
• Acquisitions are added to an asset pool and
disposals are subtracted from the asset pool.
• Reconciliation to the cash flow requires calculation
of the net salvage value.
• From Canadian tax rules, an asset class remains
open as long as there are assets remaining in it.
• If there is a loss on disposal or recaptured CCA:
 if the asset class remains open, the loss or recaptured
CCA is allocated on an ongoing basis by the declining
balance method at the asset group’s CCA rate;
 if the asset class must be closed because there are no
assets remaining in it, the terminal loss or recaptured
CCA is applied to the income.
EECE 450 — Engineering Economics
12-13
Accounting & Eng’g Economy …
 A capital gain is realized when an asset is
sold for more than its original cost.
 50% of the capital gain (selling price 
original cost) is taxed at the marginal rate.
 Net salvage value (NSV):
• Asset class open: NSV = S.
• Asset class closed: NSV = S + T(BdS).
S = Salvage value (before-tax proceeds from
disposal)
T = marginal tax rate
Bd = Book value at disposal (UCC)
EECE 450 — Engineering Economics
12-14
CCA and Capital Costs
 When a capital asset is acquired, the present
value of the net capital investment is:
 dTC 1  i 2 
B 1 

i

d
1

i


B  capital cost of asset (cost basis)
d  CCA rate for the specified asset class
TC  firm’ s marginal tax rate
i  discount rate
 Use this formula only if it is valid to assume
the full CCA will be taken every year.
EECE 450 — Engineering Economics
12-15
CCA and Capital Costs …
 When we dispose of a capital asset, the
present value of the net salvage is:
 dTC   1 
S 1 



N
 i  d   1  i  
S  salvage value
d, TC , i  as defined earlier
N  lifetime (year of disposal)
 Use this formula if the CCA class will remain
open, i.e. other assets remain in the asset
class after the project is complete.
EECE 450 — Engineering Economics
12-16
Working Capital Requirements
 Time lags exist between dispensing cash for
expenses and receiving cash from sales.
 Working capital = injection of cash, or cash
equivalents, to cover these time lags.
 Most investments require an initial investment
in working capital. The working capital is
recovered entirely at the end of the project.
 There may be changes in the level of working
capital required throughout the project.
 Working capital does not gain value nor does
it depreciate in value during the project.
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12-17
After-tax Rate of Return
 It is usually a complex matter to obtain the
after-tax MARR and it cannot usually be
obtained from the before-tax MARR, however
MARRafter-tax  MARRbefore-tax(1T) is a
reasonable approximation.
 We will assume, unless it is otherwise clearly
stated, that we are using an after-tax MARR
when we analyze the economics of a project.
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12-18
Comprehensive Example
 Johnston Forwarding Inc. is considering the
purchase of twenty new trucks for a special
purpose fleet in their freight division. Each
truck costs $67,500. They are expected to be
in service for eight years, then be salvaged
for $5000 each. The trucks will be added to
an existing CCA Class 10 asset pool. Each
truck is expected to generate $20,750 in
annual revenue, net of direct operating costs.
Johnston’s maintenance cost centre charges
$1550 per truck annually. (Continued …)
EECE 450 — Engineering Economics
12-19
Comprehensive Example …
 There is also a fixed annual cost of $35,000
to cover management and administration of
the twenty trucks in the proposed fleet. Each
truck will require an immediate investment of
$7500 in net working capital. Johnston uses
a minimum acceptable rate of return of 14
percent to analyze investments of this type.
Johnston’s marginal tax rate is 30 percent.
 Determine whether Johnston Forwarding Inc.
should invest in the new trucks. Use both a
value and a rate of return criterion.
EECE 450 — Engineering Economics
12-20
Comprehensive Example …
Purchase cost per truck :
Salvage value per truck :
Number of truck s:
Annual net revenue per truck :
Annual maintenance charge per truck :
Fixed costs:
Work ing capital per truck :
CCA rate:
Tax rate:
MARR:
Planned lifetime (years):
$67,500
$5,000
20
$20,750
$1,550
$35,000
$7,500
30%
30%
14%
8
Truck purchase
PV(CCA tax shield gained)
Investment in work ing capital
PV(Salvage)
PV(CCA tax shield lost on salvage)
PV(recovered work ing capital)
PV(net after-tax operating cash flow)
-$1,350,000.00
$259,180.62
-$150,000.00
$35,055.91
-$7,170.53
$52,583.86
$1,133,274.45
NPV=
IRR=
-$27,075.69
13.471%
Johnston Forwarding Inc. should not invest in the trucks.
EECE 450 — Engineering Economics
12-21
Suggested Problems
 12-23 (NPV), 25 (PBP & IRR), 37 (PBP, NPV
& IRR), 38 (NPV & IRR), 39 (NPV & IRR), 50,
51.
 At the time of disposal of an asset, unless it is
otherwise explicitly stated, assume:
• the CCA asset class continues (has other assets
remaining in it) and has greater value before the
disposal than the value of the asset being
salvaged;
• the asset disposal occurs at year-end, after the
CCA has been taken for the final year.
EECE 450 — Engineering Economics
12-22