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Understanding Income Taxes and their Impact on Economic Analysis

Learn how income taxes affect cash flow and investment decisions, and how to integrate tax considerations into economic analysis techniques.

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Understanding Income Taxes and their Impact on Economic Analysis

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  1. Chapter 11 - Income TaxesClick here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

  2. EGR 403 - The Big Picture • Framework:Accounting& Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods • Ch. 5 - Present Worth • Ch. 6 - Annual Worth • Ch. 7,7A,8 - Rate of Return (incremental analysis) • Ch. 9 - Benefit Cost Ratio & other methods • Refining the analysis • Ch. 10, 11 - Depreciation & Taxes • Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA14

  3. Income Taxes • Taxes have an impact on cash flow and affect the decisions management makes concerning investments. • Integrating tax considerations into economic analysis requires a thorough understanding of two issues. • How the taxes are imposed. • How they affect the economic analysis techniques. EGR 403 - Cal Poly Pomona - SA14

  4. A Partner(s) in the Business • 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 item. • Collected by • Federal • State • County • City For simplification 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 in the manner in which they are administered. EGR 403 - Cal Poly Pomona - SA14

  5. General Process • Understand the tax laws affecting the project of interest. • Estimate the cash flows without considering the effect of taxes. • Adjust the cash flow based on the effects of depreciation and income taxes. • Determine the after-tax measure of interest (PW, IRR, payback, etc.). EGR 403 - Cal Poly Pomona - SA14

  6. Calculation of Taxable Income • Tax laws can be very complex leading to very complex calculations. • A tax is just another disbursement for services rendered. EGR 403 - Cal Poly Pomona - SA14

  7. Classification ofBusiness Expenditures • Capital expenses. • Expenditures for depreciable assets. • Generally those items having a life in excess of one year. • Expenditures for non-depreciable assets. • Generally land, as land has no finite life. • Operating expenses. • Materials, labor, overhead, rents, leases, equipment having a life of less than one year. EGR 403 - Cal Poly Pomona - SA14

  8. Taxable Income of Business Firms • Taxable income = gross income - operating expenses - depreciation EGR 403 - Cal Poly Pomona - SA14

  9. Income Tax Rates • Rates 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. • US corporate income tax rates are found in internal revenue service form 1120. EGR 403 - Cal Poly Pomona - SA14

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  13. Example of How to Use Table • Corporate Before Tax Profit: $15,000,000 • Federal Tax (from tax rate table): = $3,400,000 + 0.35 ($15,000,000 - $10,000,000) = $3,400,000 + $1,750,000 = $5, 150,000 EGR 403 - Cal Poly Pomona - SA14

  14. When you sell a capital asset for more than the book value, it is treated as a profit or a gain and taxes are due EGR 403 - Cal Poly Pomona - SA14

  15. Economic Analysis Taking Income Taxes Into Account Principle elements in the after-tax analysis: • Before-tax cash flow • Investment • Benefits- costs • Depreciation • Taxable income (BTCF - depreciation) • Income taxes (Taxable income x incremental tax rate) • After tax cash flow (BTCF - income taxes) • IRR EGR 403 - Cal Poly Pomona - SA14

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  20. Figuring Personal Income Taxes Gross Income (wages, tips, interest, dividends) Less: Adjustments (tax deferred investments: 401k, IRA) = adjusted gross income Less: exemptions (2750/dependent, includes you) Less: deductions - choose the most favorable of: Standard deduction: $4300 if single or $7200 if married (1999) [Note: $4700 single or $7850 (2002)], or Itemized deductions (donations, some taxes, interest on your home, major medical expenses and losses) = Taxable income Use tables to determine taxes owed on taxable income. EGR 403 - Cal Poly Pomona - SA14

  21. Example 1 - Single Student • Gross Income: $8000 • Adjusted Gross Income: $8000 • Deduction for one exemption: - $2750 • Standard deduction: - $4300 (1999 tax year) • Taxable income = $950 • Taxes owed = 0.15 * $950 = $142.50 EGR 403 - Cal Poly Pomona - SA14

  22. Example 2 -Young Single Engineer • Salary: $50,000 • Tax Deferred Investment into 401k: -$5000 • Adjusted Gross Income = $45,000 • One exemption: - $2750 • Standard deduction: - $4300 (1999 tax year) • Taxable Income = $37,950 • Taxes: $3863.50 + 0.28 ($37,950 - $25750) = $3863.50 + $3416 = $7279.50 EGR 403 - Cal Poly Pomona - SA14

  23. Young Single Engineer Buys a Condo • Cost: $220,000 with down payment of $20,000 • Loan: $200,000, 30 years, 6% nominal • Monthly Payments: $1199.10 (fixed!) • Approximate first year interest: $12,000 • Tax savings from $12,000 itemized deduction: 0.28 * $12,000 = $3360 • Property taxes (approx. 2% of value) are also deductable EGR 403 - Cal Poly Pomona - SA14

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