TAXES

compulsory contribution to state revenue, levied by

the government on workers' income and business
profits, or added to the cost of some goods, services,
and transactions.

Other words used in place of tax are;

levy, tariff, duty, toll, excise, impost, contribution,
assessment, tribute, tithe, charge, fee
 INFLATION
a general increase in prices and fall in the purchasing value of money.
 INFLATION RATE
the rate at which prices increase over time, resulting in a fall in the purchasing
value of money.
"the average inflation rate over the decade was 5 per cent"
Purchasing Power and Inflation Rates
Suppose Ahmad wants to buy golf balls. Each ball costs $5. If he
has $1000, how many balls can be purchased now?

If he decides to invest $1000 in the bank at compound interest

rate of 5.5%, how many ball he can purchase after one year if
inflation rate is zero
Suppose Ahmad wants to buy golf balls. Each ball costs $5. If he has $1000, how
many balls can be purchased now?

If he decides to invest $1000 in the bank at compound interest rate of 5.5%, how many ball he
can purchase after one year with inflation rate equal to zero

Numner of Balls purchased after one year = 1055 / 5 = 211

Purchasing Power and Inflation Rates
But inflation rate is not zero, it is 2%.
How many balls can he purchase after one year?
Purchasing Power and Inflation Rates

Suppose inflation rate is to be included in the problem, find the

number of golf balls purchased after one year for following
inflation rates:
f = 2, 5, 10, 15
 Purchasing Power with Increasing Inflation Rate
Suppose inflation rate is to be included in the problem, find the
number of golf balls purchased after one year for following
inflation rates:
f = 2, 5, 10, 15

Price after one year is Price * ( 1 + f % )

Inflation Free Interest Rate ( i‘)
 CALCULATIONS WITH REAL INTEREST RATE

You receive $ 1.2 million from your father in year 2017. You decide to deposit
this gift in bank for a period of 55 years. Bank interest rate is 8% per year . How
much you will receive after 55 years in terms of 2017_base year.
Suppose Inflation rate is 6%. What is real value of 82.7 Millions based on
claculations in year 2017. Since, i = 8% and f = 6%, real ineterst rate i‘ will be
CALCULATION OF AFTER-TAX
Internal Rate of Return (IRR)
Including INFLATION RATE
When inflation factor is included in Cash Flow, Zero_Year based Cash Flow is
converted to Actual Dollars ($) Cash flow.

Example: Suppose a machine‘s initial price is $16000 and salvage value is $1000. It
has a life of five years. It will generate cash flow as under:

Year Cah Flow

0 -16000
1 4000
2 4000
3 4000
4 4000
5 4000
5 (salvage value) 1000
(a) Now convert the Zero_Year based Cash Flow to Actual Dollars using inflation
rate of 10% as under
(b) Use straight line depreciation method (SLM) and generate After-Tax Cash flow, if
Tax Rate is 40%.
Solution:
Since, B = $ 16000, S = $ 1000, N = 5 Years,
dt = ( B – S) / N = ( 16000 – 1000 ) / 5 = $ 3000
Calculation of Taxable Income, Taxes and After-Tax Cash Flow is shown as under:
(c) What is ZERO-Year based After-Tax Cash Flow of the Actual Dollars cash flow as
found in step (b)

Solution:

The Actual Dollars Cash Flow as found from part (b) is:
To convert the Actual Dollars cash flow to ZERO-Year based After-Tax Cash Flow,
multiply it with corresponding (P/F, f, n) factor. ( where f = inflation factor)

Following Table shows the conversion of Cash Flow to Zero_Year based

Present Worth equation of zero_year based cash flow

PW ( i) = -16000 + 3491 ( P / F , i ,1 ) + 3392 ( P / F , i ,2 )

+ 3302 ( P / F , i ,3 ) + 3220 (( P / F , i ,4 )
+ 3145 ( P / F , i ,5 ) + 1000 ( P / F , i ,5 )

When i = 3%, PW (3%) = 44.85

i = 4%, PW (4%) = -412.35

Interpolation gives us i* = 3.1 %

So, After-Tax Internal Rate of Return ( IRR) = 3.1%

when inflation factor is 10%
• Solved Example
Before-Tax IRR
After-Tax IRR
Convert Zero_Year based cash flow to Actual_Dollars Cash flow if
Inflation factor is 5%
Convert Zero_Year based cash flow to Actual_Dollars Cash flow for
Inflation factor of 5%
Convert Actual_Dollars Cash flow to Zero_Year based cash flow using
conversion factor ( P/F, inflation rate, year). Inflation rate is 5%
Find present worth of Zero_Year based cash
flow using interest rate of 4 percent
Find present worth of Zero_Year based cash
flow using interest rate of 5 percent
 Find
Internal Rate of Return
( IRR )
 CHOICE OF
TECHNOLOGY
(REPLACEMENT ANALYSIS)
OLD TECHNOLOGY PLANT
NEW (MODERN) TECHNOLOGY PLANT
Initial Price of Old Plant (Po)
Initial Price of New Plant (Pn)
Service Life of old Technology Plant (no)
Service Life of new Technology Plant (nn)
Operation & Maintenance Costs per year
(OMo) Operation & Maintenance Costs per year
(OMn)
Annual Equivalent Cost of old Plant (Ao)
Annual Equivalent Cost of new Plant (An)
Variable Cost per unit (vo)
Variable Cost per unit (vn)
Total Fixed Cost of Old Plant (FCo)
Total Fixed Cost of New Plant (FCn)
 Total Cost per year for Old Technology , TCo
0 1 2 3 n

Ao Ao Ao Ao

Po
If Old Plant has initial cost Po and service life of no years, then Annual Equivalent
cost of plant Ao is found using following formula
Ao  Po ( Ao / Po , i, no )
Since Operation & Maintenance cost per year of old Technology is OMo, total
fixed cost will be; FCo = Ao + OMo
Therefore, Total cost of producing Q units per year will be;
TCo  FCo  vo Q
 Total Cost per year for New Technology , TCn
0 1 2 3 n

An An An An

Pn
If new Plant has initial cost Pn and service life of nn years, then Annual cost of
plant An is found using following formula
An  Pn ( An / Pn , i, nn )
Since Operation & Maintenance cost per year of new Technology is OMn, total
fixed cost will be; FCn = An + OMn
Therefore, Total cost of producing Q units per year will be;
TCn  FCn  vn Q
 BREAKEVEN QUANTITY Q*

At Breakeven point
TCo  TCn
FCo  voQ*  FCn  vnQ *
Ao  OM o  voQ*  An  OM n  vnQ *

Therefore

( An  OM n )  ( Ao  OM o )
Q* 
vo  vn
 BREAKEVEN QUANTITY FOR TWO TECHNOLOGIES
If Q < Q*, choose old Technology; if Q>= Q*, choose new Technology

TCo  Ao  OM o  voQ

TCn  An  OM n  vnQ
e c h n o logy is
New T is region
Costs

n th
better i
ri n
tte
y i s be
n olog ion
Tech is reg
Old th

( A  OM n )  ( Ao  OM o ) Quantity to be produced(Q)
Q*  n
vo  vn
Example:

Two technologies are under consideration for a manufacturing plant. Company uses 8%
as interest rate.
 
Technology 1 is old styled and has the following attributes:
Purchase price = Rs 400,000, Service Life = 10 years, Annual Operation and
Maintenance costs are Rs 7800. Variable cost of one unit is Rs 8.9.
 
Technology 2 is new (modern) and uses automated technology. It has the following
attributes:
Purchase price = Rs 8,600,000, Service Life = 13 years, Annual Operation and
Maintenance costs are Rs 15,800. Variable cost of one unit is Rs 2.7.
 
Find break-even Quantity (Q*).
Solution:

i = 8%

For OLD Technology,

 
Po = Rs 400,000, no = 10 years, OMo = Rs 7800. vo= Rs 8.9 per unit.
 
Find Ao from the formula;

Ao = Po ( Ao / Po, i%, n ) = Po ( Ao / Po, 8%, 10)

= 400,000 (0.14903) = 59,612

TCo = Ao + OMo + vo Q = 59,612 + 7800 + 8.9 Q = 67,412 + 8.9 Q

i = 8%
 
For NEW Technology

Pn = Rs 8,600,000, nn = 13 years, OMn = Rs 15800. vn= Rs 2.7 per unit.

 
Find An from the formula;

An = Pn ( An / Pn, i%, n ) = Pn ( An / Pn, 8%, 13)

= 8,600,000 (0.12652) = 1,088,072

TCn = An + OMn + vn Q = 1,088,072 + 15800 + 2.7 Q = 1,103,872 + 2.7 Q

 
 BREAKEVEN QUANTITY FOR TWO TECHNOLOGIES
If Q < 167171, choose old Technology; if Q>= 167171, choose new Technology

TCo  59612  7800  8.9Q

TCn  1088072  15800  2.7Q

e c h n o logy is
New T is region
Costs

n th
better i
ri n
tte
y i s be
n olog ion
Tech is reg
Old th

(1088072  15800)  (59612  7800)

Quantity to be produced(Q)
Q*   167171
8.9  2.7
How is unit cost v derived?
If Plant/machine capacity is P ( number of units produced per hour) and Labor
rate is L (Rs per hour), then unit cost is

Rs
L hour Rs
v  
P unit unit
hour

Example

Suppose Machine produces 3 units per hour ( P = 3)

Labor rate is Rs 15 per hour ( L = 15 )

So, unit cost v = L / P = 15 / 3 = Rs 5 per unit

Example
Suppose the two technologies have following Labor costs and Production rates;

Old Technology Plant

Labor cost ( L ) = Rs 16 per hour

Production Rate ( P ) = 4 units per Hour

New Technology Plant

Labor cost ( L ) = Rs 8 per hour

Production Rate ( P ) = 16 units per Hour

Find unit costs vo and vn

vo  L  16  Rs 4 / unit vn  L  8  Rs 0.5 / unit

P 4 P 16

Note, unit variable cost of old technology is 8 times more than new technology