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INFO 630 Evaluation of Information Systems Prof. Glenn Booker

INFO 630 Evaluation of Information Systems Prof. Glenn Booker. Week 10 – Chapters 16-18. Income Taxes and After-Tax Cash-Flow Streams. Chapter 16. Based on notes from Tockey. Income Taxes and After-Tax Cash-Flow Streams Outline. Taxes and income taxes, defined

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INFO 630 Evaluation of Information Systems Prof. Glenn Booker

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  1. INFO 630Evaluation of Information SystemsProf. Glenn Booker Week 10 – Chapters 16-18 INFO630 Week 10

  2. Income Taxes and After-Tax Cash-Flow Streams Chapter 16 Based on notes from Tockey INFO630 Week 10

  3. Income Taxes and After-Tax Cash-Flow StreamsOutline • Taxes and income taxes, defined • Federal income taxes for corporations • Effective income tax rates • Combining effective federal, state, and local income tax rates • Calculating after-tax cash-flow streams • Tax credits • Inflation and after-tax cash-flow streams INFO630 Week 10

  4. Taxes • Tax • E.g., sales tax, property tax, excise tax, … • Income tax • Really a tax on net income (aka profit) A charge, usually of money, imposed by an authority on persons or property for public purposes, or a sum levied on members of an organization to defray expenses INFO630 Week 10

  5. Why Important? • Taxes can have a dramatic effect on profitability • Amount and timing usually know ahead of time • Handles as expense in proposal cash-flow stream • Income Tax another issue • Do not know how much to pay until know how much profit • Rate vary and can be as high as 50% • Including federal, state and local taxes INFO630 Week 10

  6. US Federal Income Taxes for Corporations Corporation’s Marginal taxable income tax rate $0 to $50,000 15% $50,001 to $75,000 25% $75,001 to $100,000 34% $100,001 to $335,000 39% $335,001 to $10,000,000 34% $10,000,001 to $15,000,000 35% $15,000,001 to $18,333,333 38% Over $18,333,334 35% Tax on net income (revenue – expense) INFO630 Week 10

  7. Computing Federal Income Taxes for Corporations • If taxable income is $450,000 Part of Marginal Tax taxable income tax rate owed First $50,000 15% $7500 Next $25,000 25% $6250 Next $25,000 34% $8500 Next $235,000 39% $91,650 Next $115,000 34% $39,100 Total $153,000 INFO630 Week 10

  8. Federal Marginal Tax Rates Note: Marginal rates are set up to give tax break to companies with < $100,000 income INFO630 Week 10

  9. Effective Income Tax Rates • Average tax rate over a range of incomes • Example • What is Effective Tax Rate over range of income between $40k and $60k? • At $40k taxable income, tax is $6000 • At $60k taxable income, tax is $10,000 INFO630 Week 10

  10. Combining Effective Federal, State, and Local Income Tax Rates • State and local income taxes are deductible as expenses on federal returns • Example • Effective federal rate is 39% • Effective state and local rate is 7% INFO630 Week 10

  11. How to address taxes • Use before-tax MARR • Accounts for taxes but results might not be accurate enough for decision analysis • Use after-tax MARR on after-tax cash flow (recall ch. 10 for more detail). • Example • After-tax MARR = (Before-tax MARR) * (1-Eff Tax Rate) • E.g. Before-tax MARR = 21%, Eff tax rate = 38% After-tax MARR = 0.21 * (1-0.38) = 0.13 = 13% INFO630 Week 10

  12. Recall Minimum Attractive Rate of Return (MARR) • A statement that the organization is confident it can achieve at least that rate of return • Aka “Opportunity cost” • By investing in A, you forego the opportunity to invest in B • If you’re confident you can get X% there, all other alternatives should be evaluated against that X% INFO630 Week 10

  13. REVIEW - Significance of the MARR • The MARR is used as the interest rate in for-profit business decisions • PW(MARR) = how much more, or less, valuable that alternative is than investing same $ in an investment that returns the MARR • i.e., PW(MARR) = $1000 doesn’t really mean you’ll gain just $1000, it means that the cash-flow stream is equivalent to $1000 more today than investing those same resources in something that returns the MARR INFO630 Week 10

  14. REVIEW - Significance of the MARR • Note: MARR is usually set by policy decision from organization’s management team • Too high or too low? • How set? • Impact? INFO630 Week 10

  15. After Tax Cash Flow Stream How to calculate • Need to know four pieces of information • Before-tax cash-flow • Loan principal and interest payments (ch 6) • Depreciation accounting (ch 14) • Effective income tax rate (this chapter) • Most straight forward method • Use table on next page • Income – positive number • Expense – negative number INFO630 Week 10

  16. Calculating After-TaxCash-Flow Streams (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 … … N/A … N/A … … … 1 … … … … … … … … 2 … … … … … … … … 3 … … … … … … … … 4 … … … … … … … … 5 … … … … … … … … INFO630 Week 10

  17. An Example Project (From Ch 3 lecture): Automated Test Equipment (ATE) • Assume one person-year of labor = $125k • Initial investment • $300k for test hardware and development equipment (Year 0) • 20 person-years of software development staff (Year 1) • 10 person-years of software development staff (Year 2) • Operating and maintenance costs • $30k per year for test hardware and dev equipment (Years 1-10) • 5 person-years of software maintenance staff (Years 3-10) • Sales income • None • Cost avoidance • $1.3 million in reduced factory staffing (Years 2-10) • Salvage value • Negligible INFO630 Week 10

  18. The ATE Example – Cash Flow Stream $645K $20K 0 1 2 3 4 5 6 7 8 9 10 -$300K Example from Ch 3 Lecture Slides To get to the next slide, assume: Loan is ($250k, 8%, 5 year, annual pmts)depreciable investment ($300K hardware)depreciation method (MACRS, 5 year)Effective income tax rate (36%)company profitable overall -$2.53M INFO630 Week 10

  19. After-Tax Cash-Flow Stream for ATE (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 $0 $250K N/A -$300K N/A $0 $0 -$50K 1 -$2.53M -$43K -$20K -$60K -$2.61M $937K -$1.65M 2 $20K -$46K -$17K -$96K -$93K $33K -$9K 3 $645K -$50K -$13K -$58K $574K -$207K $376K 4 $645K -$54K -$9K -$35K $601K -$216K $366K 5 $645K -$58K -$5K -$35K $605K -$218K $365K 6 $645K -$17K $628K -$226K $419K 7 $645K $645K -$232K $413K 8 $645K $645K -$232K $413K 9 $645K $645K -$232K $413K 10 $645K $645K -$232K $413K INFO630 Week 10

  20. Tax Credits • At a given effective income tax rate, each additional dollar of income gives (before tax) • E.g., at 36% effective income tax rate • Tax credits, in contrast, are added directly to the after-tax cash-flow stream • $1 in tax credit gives $1 in after-tax income $1.00 – (Effective income tax rate as cents) of additional after-tax income $1.00 – (0.36) = $0.64 Note: Currently there are no tax credits for software related activities INFO630 Week 10

  21. Tax Credits • Purpose • Used to stimulate investment in a particular area of economy • Example • Next slide • $300k investment at EOY0 leads to $30k investment tax credit, EOY0 after-tax cash-flow instance -$50k +$30k  -$20k • Compared to slide 19 • See underlined area on next slide EOY0 = end of year zero INFO630 Week 10

  22. After-Tax Cash-Flow Stream with 10% Investment Credit (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 $0 $250K N/A -$300K N/A $0 $0 -$20K 1 -$2.53M -$43K -$20K -$60K -$2.61M $937K -$1.65M 2 $20K -$46K -$17K -$96K -$93K $33K -$9K 3 $645K -$50K -$13K -$58K $574K -$207K $376K 4 $645K -$54K -$9K -$35K $601K -$216K $366K 5 $645K -$58K -$5K -$35K $605K -$218K $365K 6 $645K -$17K $628K -$226K $419K 7 $645K $645K -$232K $413K 8 $645K $645K -$232K $413K 9 $645K $645K -$232K $413K 10 $645K $645K -$232K $413K NOTE $300k investment at EOY0 leads to $30k investment tax credit, EOY0 after-tax cash-flow instance -$50k  -$20k INFO630 Week 10

  23. Inflation and After-Tax Cash-Flow Streams • Some cash-flow components are affected by inflation … • Revenues, O&M costs, future salvage values, etc. • … and some are not • Loan repayment schedules, lease fees, depreciation amounts, etc. • When calculating after-tax cash-flows from before-tax cash-flows, use actual dollar analysis • Separate constant dollar components from actual dollar components and apply inflation adjustments only to actual dollar components INFO630 Week 10

  24. Recall - Accounting for Inflation (Ch 13) Two Methods • Actual dollar analysis • Cash-flow instances represent actual out-of-pocket dollars paid/received at that time • Aka current dollars, escalated dollars, inflated dollars, … • Constant dollar analysis • Cash-flow instances represent hypothetical constant purchasing power amounts • Aka real dollars, deflated dollars, today’s dollars, … INFO630 Week 10

  25. REVIEW - Actual-Constant Dollar Analogy Does this analogy help anyone? Just curious… INFO630 Week 10

  26. Key Points • Most taxes can be estimated beforehand, income taxes cannot • “Income tax” is really a tax on profit • Federal tax rates are “marginal rates” • Effective income tax rates approximate actual income tax rates over ranges of taxable incomes (to simplify computations) • State and local income taxes are deductible from federal income taxes • A table for calculating after-tax cash-flow streams is helpful • Tax credits add directly to after-tax income • Inflation affects elements of cash-flow streams differently INFO630 Week 10

  27. Consequences ofIncome Taxes onBusiness Decisions Chapter 17 Based on notes from Tockey INFO630 Week 10

  28. Consequences of Income TaxesOutline • Additional Areas that may be impacted by income taxes • Interest expenses and income taxes • Interest income and income taxes • Depreciation method and income taxes • Depreciation recovery period and income taxes • Capital gains and losses for corporations • Gain or loss when selling or scrapping depreciable assets • Comparing financing methods in after-tax cash-flow terms • After-tax analysis of replacements INFO630 Week 10

  29. Interest Expenses and Income Taxes • Most loan interest is deductible • Effectively reduces the interest rate • Example • P-Systems and Q-Soft have identical incomes ($465k) and all other expenses • P-Systems averages $200k in loans at 9%,Q-Soft has no loans P-Systems Q-Soft Income before interest deduction $465,000 $465,000 Interest expense $18,000 $0 Taxable income $447,000 $465,000 Taxes (effective rate, 36%) $160,920 $167,400 INFO630 Week 10

  30. Interest Expenses and Income Taxes (cont) • P-Systems pays $6480 less income tax • Subtracting this from their interest expense means P-Systems effectively paid only $11,520 in interest • In general $11,520 $200,000 = 0.0576 = 5.76% EffectiveAfterTaxInterestRate = (1-EffectiveIncomeTaxRate) * LoanInterestRate P-Systems’ EffectiveAfterTaxInterestRate = (1-36%) * 9% = 5.76% Result:When interest rates are tax deductible, borrowing money might not be quite as expensive.

  31. Interest Income and Income Taxes • Most interest income (loan) is considered taxable • Interest from municipal bonds is an exception • Usually exempt from federal income tax • Two bonds to compare (more in Ch 18) • $10k municipal bond at 9% • $10k corporate bond at 12% • Buyer’s effective income tax rate = 35% INFO630 Week 10

  32. Interest Income and Income Taxes (cont) • Comparing in pre-tax terms • IRR of $10k corporate bond is 12% • IRR of $10k municipal bond is 9% • Comparing in post-tax terms • Corporate bond’s $1200 interest is taxed at 35%, or $420 • Actual after-tax income is $780 • After-tax IRR of $10k corporate bond is 7.8% • After-tax IRR of $10k municipal bond is still 9% Result: “Income taxes can significantly impact the desirability of alternatives” INFO630 Week 10

  33. Depreciation Method and Income Taxes • Depreciation method (Ch 14) will affect the after-tax cash-flow stream • Two depreciation methods • Straight-line • 150% declining balance switch to straight line • Example • Q-Soft is starting a new ASP line of business • 7 year planning horizon • Non-depreciable cash-flow stream shown • $120K of depreciable expenses, 5 year useful life • No borrowing • Profitable overall • Effective income tax rate is 38% • After-tax MARR is 17% INFO630 Week 10

  34. After Tax Cash Flow5-Year Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$24K -$4K $1.5K $21.5K 2 $40K -$24K $16K -$6.1K $33.9K 3 $80K -$24K $56K -$21.3K $58.7K 4 $90K -$24K $66K -$25.1K $64.9K 5 $70K -$24K $46K -$17.4K $52.5K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K INFO630 Week 10

  35. After Tax Cash Flow150% Declining-Balance Switching to Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$36.0K -$16K $6.1K $26.1K 2 $40K -$25.2K $15K -$5.6K $34.4K 3 $80K -$24.0K $56K -$21.3K $58.7K 4 $90K -$24.0K $66K -$25.1K $64.9K 5 $70K -$10.8K $59K -$22.5K $47.5K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K INFO630 Week 10

  36. Comparing Depreciation Methods After Taxes Straight 150% Declining-balance line switching to straight-line PW(17) of the depreciation amounts -$76,784 -$81,897 PW(17) of the income tax payments -$33,791 -$31,848 PW(17) of the after-tax cash flow stream $1040 $2983 After tax IRR 17.25% 17.74% NOTE: Which is better? Why? • From after tax perspective - • - 150% switching to straight • - More tax dollars avoided earlier, just from changing depreciation strategy INFO630 Week 10

  37. Depreciation Recovery Period and Income Taxes • Depreciation recovery period also affects the after-tax cash-flow stream • In general it is better to write off more dollars sooner from an after-tax perspective • Shorter recovery periods better than long ones • Note: Might lead to higher taxes in later years, but PW of after-tax cash-flow stream will be greater • Try the same Q-Soft example with 3-year straight-line depreciation INFO630 Week 10

  38. 3-Year Straight-Line Depreciation (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$40K $0 N/A -$120K N/A -$40K $15.2K -$144.8K 1 $20K -$40K -$20K $7.6K $27.6K 2 $40K -$40K $0K $0.0K $40.0K 3 $80K -$40K $40K -$15.2K $64.8K 4 $90K $90K -$34.2K $55.8K 5 $70K $70K -$26.6K $43.4K 6 $50K $50K -$19.0K $31.0K 7 $30K $30K -$11.4K $18.6K INFO630 Week 10

  39. Comparing Depreciation Recovery Periods After Taxes From slide 34 5-year 3-Year straight-line straight-line PW(17) of the depreciation amounts -$76,784 -$88,383 PW(17) of the income tax payments -$33,791 -$29,383 PW(17) of the after-tax cash flow stream $1040 $16,324 After tax IRR 17.25% 20.86% • NOTE: • 3-year higher PW of depreciation amounts and lower PW income taxes because of accelerated write offs • PW of after tax cash-flow stream and IRR favor 3-year • Conclusion: from after-tax perspective the sooner you can write off, the better INFO630 Week 10

  40. Capital Gains and Losses for Corporations • Ordinary income comes from activity • Capital gain comes from increase in value without explicit activity • Capital loss is opposite • “Short-term” gains are <1 year • Long-term gains are >1 year • Taxes on short-term and long-term gains may be different INFO630 Week 10

  41. Capital Gains and Losses for Corporations (cont) • Recently, capital gains were taxed like ordinary income but with a 34% limit • Capital gains could be taxed at less than, or equal to, 34%, but not more • Examples ( See Income tax rates Ch 16) • AlphaSystems has $55k of ordinary income and $20k of capital gain, capital gain would be taxed at 25% • BetaSystems has $80k of ordinary income and $20k of capital gain, capital gain would be taxed at 34% • GammaSystems has $180k of ordinary income and $20k of capital gain, capital gain would be taxed at 34% (even though GammaSoft is otherwise in a 39% bracket) INFO630 Week 10

  42. Capital Gains and Losses for Corporations (more) • May be restrictions on addressing capital losses • Only usable to offset capital gains • Can carry capital losses back up to 3 years, carry forward up to 5 • This is why politicians make such a big deal about capital gains taxes! • Examples • DeltaSystems has no ordinary income , $10k of capital loss this year, and $20k of capital gain last year  amend last year’s tax return to only $10k of capital gain • ThetaSystems has no ordinary income , $10k of capital loss this year, and no capital gain for last 3 years  capital loss is held in reserve against future gains for up to 5 years INFO630 Week 10

  43. Gain or Loss When Selling or Scrapping Depreciable Assets • When a depreciable asset is sold or scrapped, the difference between its book value and amount received needs to be addressed • Amounts less than book value subtract from ordinary income • Amounts greater than book value add to ordinary income (“depreciation recapture”) INFO630 Week 10

  44. Comparing Financing Methods in After-Tax Cash-Flow Terms • When buy asset • Three ways of paying for assets • Buy with retained earnings • Buy with money already earned as profit • Owned entirely by company • All tax benefits from ownership is available • Buy with a loan • Borrow all or part of acquisition costs • Lease • Lease fee’s deductible as ordinary expense • Tax consequences are different for each INFO630 Week 10

  45. Comparing Financing Methods in After-Tax Cash-Flow Terms Example: OmegaSoft buys $60k in equipment to support ASP service • $9000 annual operating and maintenance costs • 7 year planning horizon • MACRS 5 year depreciation • OmegaSoft is profitable overall • Effective income tax rate is 43% • After-tax MARR is 10% INFO630 Week 10

  46. Buy With Retained Earnings (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 0.0K N/A -$60K N/A $0K $0K -$60.0K 1 -$9.0K -$12.0K -$21.0K $9.0K $0.0K 2 -$9.0K -$19.2K -$28.2K $12.1K $3.1K 3 -$9.0K -$11.5K -$20.5K $8.8K -$0.2K 4 -$9.0K -$6.9K -$15.9K $6.8K -$2.2K 5 -$9.0K -$6.9K -$15.9K $6.8K -$2.2K 6 -$9.0K -$3.5K -$12.5K $5.4K -$3.6K 7 -$9.0K -$9.0K $3.9K -$5.1K INFO630 Week 10

  47. Buy With 13% Loan (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 0.0K $60K N/A -$60K N/A $0K $0K $0.0K 1 -$9.0K -$5.8K -$7.8K -$12.0K -$28.8K $12.4K -$10.2K 2 -$9.0K -$6.5K -$7.1K -$19.2K -$35.3K $15.2K -$7.4K 3 -$9.0K -$7.4K -$6.2K -$11.5K -$26.7K $11.5K -$11.1K 4 -$9.0K -$8.3K -$5.2K -$6.9K -$21.1K $9.1K -$13.4K 5 -$9.0K -$9.4K -$4.2K -$6.9K -$20.1K $8.6K -$14.0K 6 -$9.0K -$10.6K -$2.9K -$3.5K -$15.4K $6.6K -$15.9K 7 -$9.0K -$12.0K -$1.6K -$10.6K $4.6K -$18.0K Note: $60k loan, 13%, 7 years, annual payments INFO630 Week 10

  48. Lease (B) (H) Before- Income (I) (A) tax (G) Tax After-tax End Cash- (C) (D) (E) (F) Taxable Cash-flow Cash-flow of flow Loan Loan Depreciable Depreciation Income Stream Stream Year Stream Principal Interest Investment Expense (B+D+F) (–Rate*G) (B+C+D+E+H) 0 -$12.0K N/A N/A -$12.0K $5.2K -$6.8K 1 -$21.0K -$21.0K $9.0K -$12.0K 2 -$21.0K -$21.0K $9.0K -$12.0K 3 -$21.0K -$21.0K $9.0K -$12.0K 4 -$21.0K -$21.0K $9.0K -$12.0K 5 -$21.0K -$21.0K $9.0K -$12.0K 6 -$21.0K -$21.0K $9.0K -$12.0K 7 -$9.0K -$9.0K $3.9K -$5.1K Note: $12K annual lease payments at end of all but last year INFO630 Week 10

  49. Comparing Financing Methods After Taxes PW(10%) Buy with retained earnings -$59,116 Buy with loan -$54,393 Lease -$56,005 Note: Looking at expenses only since this is a service alternative. INFO630 Week 10

  50. Loans, Interest Rates, and MARRs • In prior example, why borrow at 13% when MARR is 10%? • In this example loan interest rate is before-tax and MARR is after-tax • When effective tax rate is 43%, actual after-tax cost of borrowing is • At an effective income tax rate of 43%, a 10% after-tax loan interest rate is equivalent to a before-tax loan interest rate of INFO630 Week 10

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