Engineering Economic Analysis Canadian Edition

1. Engineering Economic AnalysisCanadian Edition Chapter 12: After-Tax Cash Flows

2. Chapter 12 … • Shows how to calculate income taxes. • Discusses incremental income taxes. • Determines combined federal and provincial income tax rates. • Calculates after-tax cash flows. • Determines after-tax performance measures, e.g. NPV, EACF, IRR, PBP, and BCR. • Evaluates projects on an after-tax basis with acquisition & disposal of assets.

3. Income Taxes • Taxes have an effect on cash flows and on the investment decisions managers make. • Integrating tax considerations into economic analysis requires a thorough understanding of two issues: • how the taxes are imposed; and • how taxes affect economic analysis techniques.

4. Income Taxes … • Federal income taxes are determined from taxable income and income tax rates. • Progressive individual federal income tax structure • Gross Income – Deductions = Taxable income. • Gross income: wages and salary, interest income, dividend income, etc. • Deductions: retirement plan contributions, business investment expenses, etc. • Personal income tax rates vary across provinces and are progressive; the exception is Alberta which uses a flat rate.

5. Income Taxes … • Average tax rate = Taxes payable/taxable income. • Marginal tax rate: tax rate applicable to the next dollar of income earned. • If the next dollar of income does not cause tax “bracket creep”, the marginal tax rate would equal the sum of the federal income tax rate + provincial income tax rate. • An individual at the 26% federal tax level and the 13.7% provincial tax level has a marginal tax rate of 39.7% (about $80,000 taxable income in B.C.).

6. Corporate Income Taxes • More complex than individual income taxes. • Corporate accountants apply Generally Accepted Accounting Principles (GAAP) to capture reality. • Income Tax Act defines specific accounting concepts: • depreciation, cost base, book value, salvage value • Combined federal and provincial corporate tax rates for British Columbia in 2007 are: • 17.62% for up to $400,000 for small businesses; • 34.12% for Canadian-controlled private corporations (CCPCs) with taxable incomes over $400,000.

7. Corporate Income Taxes … Income Statement for TMU Corporation for the year ending December 31, 2007 Operating revenues OR Less: Operating costs OC Before-tax cash flow (BTCF) OR  OC CCA CCA Debt interest I Taxable income OR  OC  CCA  I Less: income taxes (rate T) T(OR  OC  CCA  I) Net Profit (loss) (OROCCCAI)(1T)

8. Accounting & Engineering Economy • Understand the tax laws affecting the project of interest. • Estimate the cash flows without considering the effects of taxes. • Adjust the cash flows based on the effects of depreciation and income taxes. • Determine the after-tax measure(s) of merit (NPV, IRR, etc.).

9. Accounting & Eng’g Economy … • Principal accounting statements: • Income statement: earnings during one year. • Cash flow statement: sources and uses of cash. • Operating revenue = Operating cost + BTCF • BTCF (Before-tax cash flow) = Debt interest + CCA + Taxable income; i.e. Taxable income = BTCF  Debt interest  CCA. • Taxable income = Net profit + Income tax; i.e. Net profit = Taxable income  Income tax. • Net profit = (Taxable income)(1  T).

10. Accounting & Eng’g Economy … • After-tax cash flow (ATCF): = Net profit + CCA + Debt interest (I) = (Taxable income)(1T) + CCA + I = (BTCF  I  CCA)(1 T) + CCA + I = (OR  OC)(1 T) + I(T) + CCA(T) • Net cash flow from operations: = ATCF – I – Dividends (DIV) = (OR  OC)(1T) + I(T) + CCA(T)  I  DIV = (OR  OC  I)(1T) + CCA(T)  DIV = Net profit + CCA  DIV

11. Accounting & Eng’g Economy … • Net cash flow = Net cash flow from operations + New equity issued + New debt issued + Proceeds from asset disposal  Repurchase of equity  Repayment of debt (principal)  Purchase of assets

12. Accounting & Eng’g Economy … • CCA deduction reduces taxable income but not the cash flow. • The actual effect of CCA is to increase the cash flow by an amount = TCCA, called the CCA tax shield. • CCA (depreciation) is added to the net profit to get the net after-tax cash flow.

13. Accounting & Eng’g Economy … • Acquiring and disposing of assets: • Acquisitions are added to an asset pool and disposals are subtracted from the asset pool. • Reconciliation to the cash flow requires calculation of the net salvage value. • From Canadian tax rules, an asset class remains “open” as long as there are assets remaining in it. • If there is a loss on disposal or recaptured CCA: • if the asset class remains open, the loss or recaptured CCA is allocated on an ongoing basis by the DB method at the asset group’s CCA rate; • if the asset class must be closed (no assets remaining), the loss or recaptured CCA is applied to the income.

14. Accounting & Eng’g Economy … • A capital gain is realized when an asset is sold for more than its original cost. • 50% of the capital gain (selling price  original cost) is taxed at the marginal rate. • Net salvage value (NSV): • Asset class open: NSV = S. • Asset class closed: NSV = S + T(BdS). S = Salvage value (before-tax proceeds from disposal) T = marginal tax rate Bd = Book value at disposal (UCC)

15. CCA and Capital Costs • When a capital asset is acquired, the net capital investment (today’s value) is: • Use this formula if it is valid to assume the full CCA will be taken every year.

16. CCA and Capital Costs … • When we dispose of a capital asset, the net salvage value (today’s value) is: • Use this formula if the CCA class will remain open (other assets remain after the project).

17. Working Capital Requirements • Time lags exist between dispensing cash for expenses and receiving cash from sales. • Working capital = injection of cash, or cash equivalents, to cover these time lags. • Most investments require an initial investment in working capital. The working capital is recovered entirely at the end of the project. • There may be changes in the level of working capital required throughout the project. • Working capital does not gain value nor does it depreciate in value during the project.

18. Debt Financing • Sometimes, borrowing money is one of the required components of an investment. • Debt interest payments are expenses that are tax-deductible, whereas repayments of principal come from after-tax cash flows. • There are various repayment schemes for loans. Some of the most common ones are: • Equal payments of blended principal + interest. • Equal payments of principal. • Interest-only payments with full payment of principal at the end of the loan.

19. After-tax Rate of Return • Since the interest on debt is tax-deductible, the cost of debt (interest rate on the loan) can be considered as an after-tax rate of return. • After-tax cost of debt: idt = id(1T) • id = before-tax cost of debt • T = marginal tax rate • This approach can not reliably give us the after-tax MARR from the before-tax MARR, however MARRafter-tax MARRbefore-tax(1T) is a reasonable approximation under some circumstances.

20. Comprehensive Example • Johnston Forwarding Inc. is considering the purchase of twenty new trucks for a special purpose fleet in their freight division. Each truck costs $67,500. They are expected to be in service for eight years, then be salvaged for $5000 each. The trucks will be added to an existing CCA Class 10 asset pool. Each truck is expected to generate $20,750 in annual revenue, net of direct operating costs. Johnston’s maintenance cost centre charges $1550 per truck annually. (Continued …)

21. Comprehensive Example … • There is also a fixed annual cost of $35,000 to cover management and administration of the twenty trucks in the proposed fleet. Each truck will require an immediate investment of $7500 in net working capital. Johnston uses a minimum acceptable rate of return of 12¾ percent to analyze investments of this type. Johnston’s marginal tax rate is 37½ percent. • Determine whether Johnston Forwarding Inc. should invest in the new trucks. Use both a value and a rate of return criterion.

22. Comprehensive Example …

23. Suggested Problems • 12-23 (NPV), 25 (PBP & IRR), 37 (PBP, NPV & IRR), 38 (NPV & IRR), 39 (NPV & IRR), 50, 51. • At the time of disposal of an asset, unless it is otherwise explicitly stated, assume: • the CCA asset class continues (has other assets remaining in it) and has greater value before the disposal than the value of the asset being salvaged; • the asset disposal occurs at year-end, after the CCA has been taken for the final year.