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, PBP, and BCR.
 Evaluates projects on an after-tax basis with
acquisition & disposal of assets.
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.
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 and 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.
12-4
Income Taxes …
 Average tax rate = Taxes payable/taxable
income.
 Marginal tax rate: tax rate applicable to the
next dollar of income earned.
 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.
• An individual at the 26% federal tax level and the
13.7% provincial tax level has a marginal tax rate
of 39.7% (about $80,000 taxable income in B.C.).
12-5
Corporate Income Taxes
 More complex than individual income taxes.
• 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
 Combined federal and provincial corporate
tax rates for British Columbia in 2007 are:
• 17.62% for up to $400,000 for small businesses;
• 34.12% for Canadian-controlled private
corporations (CCPCs) with taxable incomes over
$400,000.
12-6
Corporate Income Taxes …
Income Statement
for TMU Corporation
for the year ending December 31, 2007
Operating revenues
Less: Operating costs
Before-tax cash flow (BTCF)
CCA
Debt interest
Taxable income
Less: income taxes (rate T)
Net Profit (loss)
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.).
12-8
Accounting & Eng’g Economy …
 Principal accounting statements:
• Income statement: earnings during one year.
• Cash flow statement: sources and uses of cash.
 Operating revenue = Operating cost + BTCF
 BTCF (Before-tax cash flow) = Debt interest +
CCA + Taxable income; i.e. Taxable income =
BTCF  Debt interest  CCA.
 Taxable income = Net profit + Income tax; i.e.
Net profit = Taxable income  Income tax.
 Net profit = (Taxable income)(1  T).
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
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
12-11
Accounting & Eng’g Economy …
 CCA deduction reduces taxable income but
not the cash flow.
 The actual effect of CCA is to increase the
cash flow by an amount = TCCA, called the
CCA tax shield.
 CCA (depreciation) is added to the net profit
to get the net after-tax cash flow.
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 DB method
at the asset group’s CCA rate;
 if the asset class must be closed (no assets remaining),
the loss or recaptured CCA is applied to the income.
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)
12-14
CCA and Capital Costs
 When a capital asset is acquired, the net
capital investment (today’s value) 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 if it is valid to assume the full
CCA will be taken every year.
12-15
CCA and Capital Costs …
 When we dispose of a capital asset, the net
salvage value (today’s value) 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 (other assets remain after the project).
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.
12-17
Debt Financing
 Sometimes, borrowing money is one of the
required components of an investment.
 Debt interest payments are expenses that are
tax-deductible, whereas repayments of
principal come from after-tax cash flows.
 There are various repayment schemes for
loans. Some of the most common ones are:
• Equal payments of blended principal + interest.
• Equal payments of principal.
• Interest-only payments with full payment of
principal at the end of the loan.
12-18
After-tax Rate of Return
 Since the interest on debt is tax-deductible,
the cost of debt (interest rate on the loan) can
be considered as an after-tax rate of return.
 After-tax cost of debt: idt = id(1T)
• id = before-tax cost of debt
• T = marginal tax rate
 This approach can not reliably give us the
after-tax MARR from the before-tax MARR,
however MARRafter-tax  MARRbefore-tax(1T) is
a reasonable approximation under some
circumstances.
12-19
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 …)
12-20
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 12¾
percent to analyze investments of this type.
Johnston’s marginal tax rate is 37½ percent.
 Determine whether Johnston Forwarding Inc.
should invest in the new trucks. Use both a
value and a rate of return criterion.
12-21
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%
37.5%
12.75%
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
$335,176.22
-$150,000.00
$38,288.43
-$10,075.90
$57,432.65
$1,055,751.80
NPV=
IRR=
-$23,426.80
12.300%
Johnston Forwarding Inc. should not invest in the trucks.
12-22
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.
12-23