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Lectures in Engineering Economy

Lectures in Engineering Economy. Prof. Corrado lo Storto DIEG, Dept. of Economics and Engineering Management School of Engineering, University of Naples Federico II email: corrado.lostorto@unina.it phone: 081-768.2932. Major issues. Income tax definition (individual and corporate)

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Lectures in Engineering Economy

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  1. Lectures in Engineering Economy Prof. Corrado lo Storto DIEG, Dept. of Economics and Engineering Management School of Engineering, University of Naples Federico II email: corrado.lostorto@unina.it phone: 081-768.2932

  2. Major issues • Income tax definition (individual and corporate) • Tax and net income • Before-tax and after-tax analysis • How to develop the format of after-tax cash flow statement? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  3. Income taxes • Since taxes are a cash outflow of a project, economic analyses should reflect the after-tax cash flow of a project in order to achieve a true reflection of the cash flow patterns. • Tax laws are imposed for revenue generation. However, a secondary purpose is that of social legislation. The laws are very complex with many exceptions. However, this lecture will focus on the fundamental concepts. • In a sense, the government shares in every profitable venture through the taxation of a portion of the profits. The contrary is also true if the individual or corporation has other profit generating activities to offset the loss in a venture. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  4. Forms of business organization for tax purposes Individual: Applicable to an employee, a sole proprietor (individual engaging in business alone) or individual members of partnerships; taxed at individual rates; Partnership: Must file annual information return, each partner is taxed on his share of partnership earnings - whether or not distributed; Corporation: Taxed at corporate tax rates unless the corporation is treated like a partnership. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  5. Forms of business organization for tax purposes • Earnings to a corporation are taxed twice: • Once while in the corporation • Once after distribution to shareholders as dividends • This occurs because dividends are usually not a tax deductible expense for the corporation. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  6. Taxation for individuals Marginal percentage rates increase as taxable income increases. Taxable income = adjusted gross income (revenue, earnings) - deductions for exemptions - itemized deductions in excess of standard deduction Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  7. Taxation for corporations Tax rates: approx. 35% currently (depends on Country) Lower rates for taxable income below $10,000,000 (approx., depends on Country) Taxable income = gross income (revenue) - expenditures for operating expenses - tax depreciation and depletion Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  8. Taxation for corporations • A key point to remember is that capital expenditures (buildings, machinery, etc.) are not deductible as operating expenses, but rather are recovered through depreciation or depletion. • A second key point to note is that depreciation when considered as a tax deduction results in less taxes and therefore is a source of cash flow to match the cash outflow when the investment is made. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  9. Example of computation of taxable income and computation of income tax for a corporation Gross Income (or revenue) $ 3,000,000 - Salaries $ 180,000 - Operating Costs $ 200,000 - Raw Materials $ 1,500,000 - Tax Depreciation $ 620,000 Taxable Income $ 500,000 Taxes Payable @ 35% $ 175,000 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  10. Example of computation of taxable income and computation of income tax for a corporation As a practical matter, we normally assume a corporate tax rate of 35% ignoring the smaller rates at lower levels of taxable income. We do this because usually the firm for which the analysis is being done is large enough to have many projects and since the lower rates may be used on only once, the marginal rate for most corporations is 35%. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  11. Capital gains and losses If the selling price of a capital asset exceeds the book value, the excess of selling price over book value is called a capital gain. If the selling price is less than book value, the difference is a capital loss. For a corporation, capital gains are taxed at ordinary corporate tax rates. Corporate capital losses can be subtracted from any capital gains during the tax year. The net remaining losses may be carried back or forward. In general, capital losses cannot be used to offset ordinary operating income. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  12. Key Accounting Concepts Financial Accounting (Or Book) Net Income - earnings after recognition of revenues less operating expenses, book depreciation, and the book tax provision. Revenues - value of product sales or services rendered. Operating Expenses - salaries, product materials, rent, etc. Capital expenditures and dividends are not operating expenses. Book Depreciation - systematic allocation of original cost over the useful life of the asset. Book Tax Provision - tax rate times income before taxes. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  13. Tax Accounting Net Income - no such term in tax accounting. Revenues - generally similar to book revenues. We assume no difference. Operating Expenses - generally similar to book definition. We assume no difference. Book Depreciation - no such term in tax accounting. Tax Depreciation – i.e., MACRS allocation of tax basis in US. Tax Basis - historical cost of asset less any accumulated tax depreciation. Taxable Income - revenues less operating expenses less tax depreciation. Current Taxes Payable - taxable income times tax rate. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  14. The Concept of Deferred Taxes Deferred income taxes is a concept associated only with the book or financial accounting. It is not a tax accounting concept. Tax accounting computes an income tax payable. It is payable for and within the current year. Book accounting also computes a provision for income taxes as a reduction of net income. Thus, the book provision for income taxes is based upon book depreciation and will differ from current taxes payable if book and tax depreciation are not equal. The difference between current taxes payable and the book tax provision is known as deferred taxes and thus is important in tracking cash. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  15. Comparison between tax and book account TaxBook Revenues $10,000 $10,000 Operating Expenses 2,000 2,000 8,000 8,000 Depreciation 4,000 2,000 Taxable Income 4,000 - Income Before Taxes 6,000 Current Taxes Payable (35%) $ 1,400 Book Provision (35%) 2,100 Net Income $ 3,900 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  16. Tax and book account, and the deferred tax Thus, our book provision for income taxes is $2,100 while our current taxes are $1,400. The difference of $700 is known as a deferred tax. The meaning of a deferred tax is that it represents a tax on current book year earnings that will be paid in a future year. The deferred tax could alternatively be computed as the difference in tax and book depreciation (4,000-2,000) times the tax rate (35%). Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  17. Tax and book account, and the deferred tax Assume the following depreciation schedules for book and tax purposes for a $10,000 asset: Tax Book Tax Deferred Accumulated YearDepreciationDepreciationDifferenceRateTaxDeferred Tax 1 800 1,000 (200) 35% (70) (70) 2 1,400 1,000 400 35% 140 70 3 1,200 1,000 200 35% 70 140 4 1,000 1,000 - 35% - 140 5 1,000 1,000 - 35% - 140 6 1,000 1,000 - 35% - 140 7 900 1,000 (100) 35% (35) 115 8 900 1,000 (100) 35% (35) 70 9 900 1,000 (100) 35% (35) 35 10 900 1,000 (100) 35% (35) -0- 10,000 10,000 -0- -0- Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  18. tax depreciation 1400 1200 1000 800 600 400 200 0 1 2 3 4 5 6 7 8 9 10 year Tax depreciation trend Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  19. The deferred tax: Key Points 1. The deferred tax in the first year is negative meaning that the current taxes payable to the government are higher than the book income tax provision. 2. Over time the exact same amount will be taken for tax depreciation as taken for book depreciation. 3. Since the statement in 2. is correct, it follows that over time the accumulated deferred tax will become zero. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  20. Taxable Income and Income Taxes Item Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  21. Example: Corporate Income Taxes Facts: Capital expenditure $ 100,000 (allowed depreciation) $ 58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold $ 840,000 Depreciation $ 58,000 Leasing warehouse $ 20,000 Question: Taxable income? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  22. Example: Corporate Income Taxes • Taxable income: • Gross income $1,250,000 • - Expenses: • (cost of goods sold) $840,000 • (depreciation) $58,000 • (leasing expense) $20,000 • Taxable income $332,000 • Income taxes: • First $50,000 @ 15% $ 7,500 • $25,000 @ 25% $ 6,250 • $25,000 @ 34% $ 8,500 • $232,000 @ 39% $ 90,480 • Total taxes $ 112,730 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  23. Example: Corporate Income Taxes • Average tax rate: • Total taxes = $112,730 • Taxable income = $332,000 • Marginal tax rate: • Tax rate that is applied to the last dollar earned • 39% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  24. Example: Net Income Calculation Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  25. Example of corporate taxation: the U.S. Corporate Tax Rate (2005) • Tax rates are progressive: the more you earn, the more you pay • Tax rates increase in stair-step fashion Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $0 + 0.15(D) $7,500 + 0.25 (D) $13,750 + 0.34(D) $22,250 + 0.39 (D) $113,900 + 0.34 (D) $3,400,000 + 0.35 (D) $5,150,000 + 0.38 (D) $6,416,666 + 0.35 (D) (D) denotes the taxable income in excess of the lower bound of each tax bracket Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  26. Capital Expenditure versus Depreciation Expenses 1 2 3 4 5 6 7 8 0 Capital expenditure (actual cash flow) $28,000 0 1 2 3 4 7 6 7 8 $1,250 $2,500 $2,500 $3,500 $2,500 $4,000 $4,900 $6,850 Allowed depreciation expenses (not cash flow) (tax depreciation according to US MACRS) Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  27. Cash Flow vs. Net Income Net income: Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow: Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, cash flows are more relevant data to use in project evaluation. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  28. Why Do We Use Cash Flow in Project Evaluation? Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  29. Example: Cash Flow versus Net Income Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  30. Net income versus net cash flow Net cash flows = Net income + non-cash expense (depreciation) $50,000 Net income $12,000 Net cash flow $40,000 $4,000 Depreciation Income taxes $8,000 $30,000 Gross revenue $6,000 Operating expenses $20,000 $10,000 $20,000 Cost of goods sold $0 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  31. Just to remember… Revenues - Operating Expenses - Depreciation (Book) = Income Before Taxes - Book Tax Provision = Net Income Key Comment: Net income does not equate to cash flow from operations as discussed later. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  32. Just to remember… Revenues - Operating Expenses - Tax Depreciation = Taxable Income x Tax Rate = Current Taxes Payable Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  33. After-Tax Economic Analyses After-tax economic analyses (ATCFs) can be performed by using exctly the same methods as before-tax analyses. The only difference is that ATCFs are used in place of before-tax cash flows (BTCFs) by including expenses (or savings) due to income taxes and then making equivalent worth calculations using an after-tax MARR. The income tax rates and governing regulations may be complex and subject to changes, but once those rates and regulations have been translated into their effect on ATCFs, the remainder of the after-tax analysis is relatively straigthforward Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  34. After-Tax Economic Analyses To formalize the procedure, the following notation is adopted: Rk= revenues from the project; this is the positive cash flow from the project during period k, Ek= cash outflows during year k for deductible expenses and interest, dk= sum of all noncash, or book, costs during year k, such as depreciation and depletion, t= effective income tax rate on ordinary income; t is assumed to remain constant during the study period, Tk= income taxes paid during year k ATCFk=ATCF from the project during year k K=0, 1, 2, …, N Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  35. After-Tax Economic Analyses Because net income before-tax (NIBT) is Rk – Ek - dk The ordinary income tax liability when Rk>(Ek-dk) is computed as Tk=-t(Rk-Ek-dk) The net income after-tax (NIAT) is then simply taxable income (i.e., net income before tax) minus the tax liability amount detemined NIATk=(Rk-Ek-dk)-t(Rk-Ek-dk) or NIATk=(Rk-Ek-dk)(1-t) The ATCF associated with a project equals the NIAT plus noncash items such as depreciation ATCFk=NIATk+dk=(Rk-Ek-dk)(1-t)+dk=(Rk-Ek)(1-t)+tdk Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  36. After-Tax Economic Analyses In many economic analyses of engineering and business projects, ATCFs in year k are computed in terms of BTCFs (i.e., year k before-tax cash flows) BTCFk=Rk-Ek Thus, ATCFk=BTCFk+Tk =(Rk-Ek)-t(Rk-Ek-dk) =(1-t)(Rk-Ek)+tdk Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  37. After-Tax Economic Analyses A Table useful to facilitate the computation of after-tax cash flows Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  38. Project Cash Flow Analysis How to develop the format of after-tax cash flow statement? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  39. Types of Cash Flow Elements in Project Analysis Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  40. Cash Flows from Operating Activities Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  41. A Typical Format used for Presenting Cash Flow Statement • Cash flow statement • + Net income • +Depreciation • Capital investment • + Proceeds from sales of • depreciable assets • Gains tax • Investments in working • capital • + Working capital recovery • + Borrowed funds • Repayment of principal • Net cash flow Operating activities Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income + Investing activities + Financing activities Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  42. Example: The Automated Machining Center Project (when projects require only operating and investing activities) • Project Nature: Installation of a new computer control system • Financial Data: • Investment: $125,000 • Project life: 5 years • Working capital investment: $23,331 • Salvage value: $50,000 • Annual labor savings: $100,000 • Annual additional expenses: • Labor: $20,000 • Material: $12,000 • Overhead: $8,000 • Depreciation Method: 7-year MACRS • Income tax rate: 40% • MARR: 15% Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  43. Example: The Automated Machining Center Project (when projects require working capital investments) • Working capital means the amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs. • How to treat working capital investments: just like a capital expenditure except that no depreciation is allowed. Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  44. Questions • Develop the project’s cash flows over its project life. • Is this project justifiable at a MARR of 15%? • What is the internal rate of return of this project? Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  45. (a) Step 1: Depreciation Calculation • Cost Base = $125,000 • Recovery Period = 7-year MACRS Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  46. (a) Step 2: Gains (Losses) associated with Asset Disposal • Salvage value = $50,000 • Book Value (year 5) = Cost Base – Total Depreciation = $125,000 - $ 91,525 = $ 33,475 • Taxable gains = Salvage Value – Book Value = $50,000 - $ 33,475 = $16,525 • Gains taxes = (Taxable Gains)(Tax Rate) = $16,525 (0.40) = $6,610 Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  47. Step 3 – Create an Income Statement Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  48. Step 4 – Develop a Cash Flow Statement Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  49. An Excel Worksheet Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

  50. Example: Net Cash Flow Table Generated by Traditional Method Using Approach 2 Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I *Salvage value Information required to calculate the income taxes Engineering Economy/income tax and after tax analysis/ 2005 /prof. corrado lo storto

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