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Chapter 11 - Income Taxes
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EGR 403 Capital Allocation Theory
Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona
EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch. 3, 4
• Analysis methods
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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
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
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.
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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 of
Business 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
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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 Taxes
Gross 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
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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
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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
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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
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