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# Taxes have an effect on cash flow and effect the investment decisions managers make Integrating tax considerations

## into economic analysis requires a thorough understanding of two issues

How the taxes are imposed How taxes affect the economic analysis techniques

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 items
Federal Stare Country City

Collected by
For simplicity, 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.

## Calculation of Taxable Income

Understand the tax laws affecting the project of interest Estimate the cash flows without considering the effect of taxes Adjust the cash flows based on the effects of depreciation and income taxes Determine the after-tax measure of merit (PW, IRR, payback, etc.)
Tax laws can be very complex, which can lead to very complex calculations A tax is just another disbursement for services rendered

Taxable

income = gross income all expenditures except capital expenditures depreciation and depletion charges

Capital Expenditures
Expenditures for depreciable life
Expenditures for non-depreciable life
Generally those items having a life in excess of one year Generally land, as land has no finite life

Operating Expenditures

Materials, labor, overhead, rents, leases, equipment having a life of less than one year

During a 3-year period, a firm had the following results (in millions of dollars):
Year 1 Gross income form sales Purchase of special tooling (useful life: 3 years) All other expenditures Cash results for the year \$200 -60 -140 \$0 Year 2 \$200 0 -140 \$0 Year 3 \$200 0 -140 \$0

## Compute the taxable income for each of the three years

The French Chemical Corporation was formed to produce household bleach. The firm bought land for \$200,000, hand a \$900,000 factory building erected, and installed \$650,000 worth of chemical and packaging equipment. The pant was completed and operations begun on April 1. the gross income for the calendar year was \$450,000. Supplies and all operating expenses, excluding the capital expenditures, were \$100,000. the firm will use modified accelerated cost recovery system (MACRS) application
What was the first-year depreciation charge? What is the first-year taxable income?

Rate 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.

## Principal elements in the after-tax analysis:

Before-tax cash flow
Investment Benefits Cost

Depreciation Taxable income (BTCF depreciation) Income taxes (Taxable income x incremental tax rate) After tax cash flow (BTCF income taxes) IRR

A medium-sized profitable corporation is considering the purchase of a \$3000 used pickup truck for use by the shipping and receiving department. During the trucks 5year useful life, it is estimated the firm will save \$800 per year after all the costs of owing and operating the truck have been paid. Truck salvage value is estimated at \$750
What is the before-tax rate of return What is the aster-tax rate of return on this capital expenditure? Assume straight-line depreciation.

An analysis of a firms sales activities indicates that a number of profitable sales are lost each year because the firm cannot deliver same of its products quickly enough. By investing an additional \$20,000 in inventory it is believed that a firm will realize \$1000 more in before-tax profits in the first year. In the second year, before-tax extra profit will be \$1500. profits for subsequent years are expected to continue to increase on a \$500-per-year gradient. The investment in the additional inventory may be recovered at the end of a 4-year analysis period simply by selling it and not replenishing the inventory. Compute:
The before tax rate of return The after-tax rate of return assuming an incremental tax rate of 39%