Ir.

Haery Sihombing/IP
Sihombing/IP
Pensyarah Pelawat 1. Terminology and Rates
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka
2. Before and After-
After-Tax Analysis
Taxes and Depreciation

6
3.

4. Depreciation Recapture and Capital Gains

5. After-
After-Tax Analysis
6. After-
After-tax Replacement
7. Value-
Value-added Analysis

TAX ECONOMIC ANALYSIS Learning Objectives

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Gross Income:
Total income for the tax year from all
INCOME TAX TERMINOLOGY AND revenue producing function of the
RELATIONS FOR CORPORATIONS enterprise.
„ Sales revenues
AND INDIVIDUALS
„ Fees
„ Rent
„ Royalties
„ Sale of assets

Important terms: Gross Income

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 The total amount of money transferred All legally recognized costs associated
from the enterprise to the various taxing with doing business for the tax year.
agencies for a given tax year. „ Real Cash Flows
„ Tax deductible for corporations :
¾ Federal Corporate Taxes are normally paid at
„ Wages and salaries
the end of every quarter and a final adjusting
„ Utilities
payment is submitted with the tax return at
the end of the fiscal year. „ Other taxes
„ Material expenses
¾ This tax is based upon the income producing
„ Etc.
power of the firm.

Income Tax Operating Expenses (E)

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„ A percentage or decimal equivalent of TI.

„ Calculated amount of money for a
„ For Federal corporate income tax T is
specified time period from which the tax
liability is determined. represented by a series of tax rates.
„ The applicable tax rate depends upon the
„ Calculated as: total amount of TI.
„ TI = Gross Income – expenses – „ Taxes owed equals:
depreciation „ Taxes = (taxable income) x (applicable rate)
„ TI = GI – E – D [1] = (TI)(T). [2]

Taxable Income (TI) 7

Tax Rate T 8
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„ Amount of money remaining each year
when income taxes are subtracted from
taxable income.
„ NPAT = TI – {(TI)(T)},
= (TI)(1-
(TI)(1-T).
„Net profits (if positive) represent funds
that are the claim of the owners of the
firm – NOT the firm!
„ NPAT can be:
„ “Saved”
Saved” by the firm,
„ Reinvested within the firm,
[3] „ Paid out as dividends to the stockholders,
„ Some combination of paying dividends and
reinvesting.

Net Profit After Tax (NPAT) Net Profit After Tax (NPAT)
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Corporate Tax Rates:

Taxable Income
„ No one single rate
Braket Braket Min Bracket Max
„ Series of “graduated”
graduated” rates 1 $0 $50,000
„ TI is partitioned into up to 8 brackets of 2 $50,000 $75,000
taxable income 3 $75,000 $100,000
„ A tax rate is then applied to each bracket of 4 $100,000 $335,000
taxable income and then summed across all 5 $335,000 $10,000,000
applicable brackets. 6 $10,000,000 $15,000,000
7 $15,000,000 $18,333,333
8 $18,333,333 Sky's the limit!

Federal Corporate Tax Rates The Eight Federal Tax Brackets (2002)
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 Example:
Taxable Income T - (%)
Braket Braket Min Bracket Max Brkt. Rate „ Assume TI = $200,000.
1 $0 $50,000 0.15 „ Determine the Federal tax liability.
2 $50,000 $75,000 0.25
„ 1st
$50,000(0.15) = $7,500 ($150,000 left)
3 $75,000 $100,000 0.34
4 $100,000 $335,000 0.39 „ Next $25,000(0.25) = $6,250 ($125,000 left)
5 $335,000 $10,000,000 0.34 „ Next $25,000(0.34) = $8,500 ($100,000 left)
6 $10,000,000 $15,000,000 0.35
7 $15,000,000 $18,333,333 0.38 „ Now we are in the 4-
4-th bracket
8 $18,333,333 Sky's the limit! 0.35 ¾ Tax all monies between $100,000 to $335,000 at 34%

Bracket Tax Rates 9 Last $100,000(0.34) = $34,000.

$34,000.
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„ Each bracket rate is termed a “marginal”

marginal” rate.
Total Tax on TI = $200,000
„ Note the bracket rates are:
„ Add the bracket tax amounts:
1. 15%
1. $7500 2. 25%
2. $6250 3. 34%
3. $8500 4. 39%
4. $34000 5. 34%
5. $56,250 6. 35%
7. 38%
8. 35%
„ Tax as a % of TI:

¾ $56,250/$200,000 = 28.13% Observations

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 „ The first $50,000 of TI is taxed at the bracket
rate of 15%.
„ Any additional TI over $50,000 flows into the
next bracket.
„ The next $25,000 or part thereof, is taxed at
the marginal bracket rate of 25%.
„ Each additional $ that moves a firm into a
higher bracket is taxed at the higher bracket’
bracket’s
tax rate.
„ A “tax bracket”
bracket” system is termed a “graduated
tax system”
system”.
„ Additional amounts of taxable income are
taxed at the associated bracket tax rate.
„ The max bracket rate is 39% and the
minimum bracket rate is 15%.

Marginal Tax Rates Tax Bracket Description

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„ Firms with lower TI pay less taxes that firms
with much higher TI.
„ Arguments now for a “flat”
flat” tax rate.
„ Debate this point in class!
„ For engineering economy studies:
„ The analyst will not know the exact TI for
the firm so,
„ Assume a flat rate which is normally 34%
for Federal Tax analysis (approximation).
„ Most states have a state and local
corporate tax structure.
„ Firms have to pay:
„ Federal corporate taxes and possibly,
„ State corporate taxes and even,
„ County or city income taxes.
„ If this is the case apply a combined tax
rate……
rate……

Observations State and Federal

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 „ Individuals report total income;
„ Assume a know state tax rate then:
„ Gross earned income;
„ Compute: „ However, individuals may not deduct most of
„ Effective Tax rate – Te as: their expenses for day to day living and
working.
„ Te = state rate + (1 – state rate)(Federal Rate)
„ Individuals must apply the various standard
„ State income taxes are deductible or itemized deductions permitted by current
law
expenses for federal income tax purposes.
„ Corporations deduct actual cash flow
expenses.

Combined Tax Rate Personal vs. Corporate

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„ Similar bracket design with 5 brackets;

„ Individual have to file as either: 1. 15%
2. 28%
„ Single,
3. 31%
„ Married,
4. 36%
„ Head of household. 5. 39.6%
„ Corporations have no such filing status other
than filing as a corporation „ The bracket amounts depend upon filing
status: (Single, Married, Head of household).

Personal vs. Corporate Individual Tax Rates

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 „ NCF represents:
„ Cash Inflow – Cash Outflows for a given time
period.
„ Fro economy studies the engineer will
estimate the future net cash flows associated
with the project over the estimated life of the
BEFORE-TAX AND AFTER-TAX project.
CASH FLOW „ Now, we define Cash Flow Before Tax (CFBT).
CFBT).

NET CASH FLOW - NCF

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„ CFBT =
„ CFBT: „ Gross income – expenses – initial
„ Actual real cash flows associated with an investment + salvage value
investment BEFORE any income tax
considerations are applied. „ CFBT= GI – E – P + S [7]

„ CFBT does not consider depreciation or

depletion amounts. Note:
„ Depreciation and depletions amounts are not
part of CFBT as they are not real cash flows per
se.

Cash Flows Before Tax ( CFBT ) 27

CFBT Defined 28
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 „ CFAT for a given time period is defined as: „ Specifically:
CFAT = GI – E – P + S –(GI-(GI-E-D)(TE)
CFAT = CFBT – Taxes. „ Note the (GI-
(GI-E-D)(Te) term.
„ The “Taxes” „ (GI – E – D) represent the taxable income
Taxes” component must be expanded to
include the impacts of depreciation and or component;
depletion. „ Multiply (GI-
(GI-E-D) by Te computes the tax on
„ Depreciation is a noncash flow but is deductible the taxable income part.
from GI and serves to moderate (lessen) the TI
„ Then the tax is subtracted from the CFBT to
amount.
yield the CFAT amounts.

Cash Flow After Tax ( CFAT) Expanding the CFAT Amount

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„ Focus on: (GI – E - D). „ A tabular approach is suggested.

„ For some time periods this term could be
negative. „ Numerous formats exist and no one
o Operating “loss”
loss” which can generate a single format or design is “the best”
best”.
“negative”
negative” tax. „ See Table and Example
o If this is the case then “so be it”
it”.
„ Suggested tabular format follows.
o Let the sign take care of itself!

Some Observations CFBT: Format

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 Tax Rate: 35.00% Discount Rate Atax 10.00%
Life 6
(1) (2) (3) (4)
Discount Rate 15.00%
CF(Signed) CF(+) CF(+) or (-) Non-CF
(Signed) (+) (+) or (-) Calculated
Time Gross Operating Investment Depreciation
Time Gross Operating Investment CFBT Period Income Expenses or Salvage Amt (+) values
Period Income Expenses or Salvage 0 $0 $0 -$550,000
0 -$550,000 -$550,000 1 $200,000 $90,000 $0 $110,000
1 $200,000 $90,000 $110,000 2 $200,000 $90,000 $0 $176,000
2 $200,000 $90,000 $110,000 3 $200,000 $90,000 $0 $105,600
3 $200,000 $90,000 $110,000
4 $200,000 $90,000 $0 $63,360
4 $200,000 $90,000 $110,000
5 $200,000 $90,000 $0 $63,360
5 $200,000 $90,000 $110,000
6 $200,000 $90,000 $150,000 $31,680
6 $200,000 $90,000 $150,000 $260,000
$1,200,000 $540,000 -$400,000 $550,000
$1,200,000 $540,000 -$400,000 $260,000
NPV Amt ($68,857.76)
IROR 10.751%
First four columns are presented…..

BTCF Format with Example ATCF Format: Example

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(7) These amounts represent

(5) (6) (7)
Intermed. Cal. (-) C.F Calculated CF Calculated CF the after-tax cash flow
Taxable Taxes CFAT t CFAT t values for years 0 – 6.
Income (TI)
-$550,000 0 The analyst can calculate
-$550,000 0
$0 $0 $110,000 1 PW, FW, AW, IROR, etc
-$66,000 -$23,100 $133,100 2 $110,000 1
using the methods in the
$4,400 $1,540 $108,460 3 $133,100 2 previous chapters.
$46,640 $16,324 $93,676 4 $108,460 3
$46,640 $16,324 $93,676 5 The Goal: Is this
$93,676 4
$78,320 $27,412 $232,588 6 investment acceptable?
$38,500 $221,500 $93,676 5
NPV -$5,075.14 $232,588 6
IROR 9.708% $221,500
Last four columns are presented…..

Format: Example ATCF Amounts from Col 7.

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 „ Best performed with a spreadsheet model
as shown.
„ Depreciation amounts can be calculated in
another spreadsheet and copied (values
only) into the ATCF worksheet. Effect on Taxes of Different
Depreciation Methods and
„ User inputs besides the CF values are the
Recovery Periods
discount rate and the tax rate.

ATCF Calculations
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„ Given, two or more depreciation (recovery) 1. Minimize the present worth at some i% over n
plans and: time periods of the tax;
„ Constant single value tax rate; 2. Maximize the present worth at some i% over
„ Same recovery period; n time periods of the taxes saved.
„ CFBT > depreciation amount for the given year; „ PWTAX is defined by:
n
„ The methods reduce the basis to the same book
value over the same time period.
PWtax ¦ (taxes in year t)(P/F,i%,t) or,
t 1
„ Compute the PW(i%) of the future tax n
savings for each plan. PWtaxes saved ¦ D (t )( P / F , i%, t )
t 1
t e

Criteria for Selection Multiple Criteria can be used

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 „ If the firm is profitable and the TI amount
„ For depreciation plans over the same
recovery period and targeting the same
salvage value:
„ The total taxes saved are equal for all
depreciation models;
„ The present worth of taxes saved is always
less for accelerated depreciation methods.
is > 0 then:
„ Using a depreciation plan that writes off more
of the asset in the early years is preferred!
„ Achieve greater tax savings early on permits
the firm to retain more after-
after-tax dollars;
„ Which can be reinvested at or above the
firm’
firm’s MARR!
„ Promote future wealth maximization!

Rule: The Goal!

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DEPRECIATION RECAPTURE
AND CAPITAL GAINS AND
LOSSES FOR CORPORATIONS

Comparing Depreciation Plans

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 „ Firms sell or dispose of assets from time to
time. „ A capital loss occurs when an asset is sold
for less than it’
it’s current book value.
„ Those assets have been fully depreciated or,
are still being depreciated for tax purposes. „ Could generate a tax savings since the
„ Assets that are disposed do have a book “loss”
loss” could be tax deductible within
value. certain rules.
„ Could be + or,
„ Could be “0”. „ CL = BVt - SP

CAPITAL GAIN OR GAIN ON SALE Capital Loss: CL

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„ Gain on Sale is defined as: „ Confine discussion to the disposal of

„ GS = Selling Price – Current Book Value productive assets.
„ Capital Gain is defined as: „ The term “Depreciation Recapture”
„ CG = Selling Price – First Cost. applies. ( DR ).
„ Certain Assets will gain value over time and
„ DR = SP – BVt [12]
could be sold for more than what was
originally paid for them. „ Three possible outcomes can happen
„ This will generate a tax liability and tax will when a productive asset is disposed at
have to be paid! time t.

Gain on Sale (Capital Gain) Sale of Productive Assets

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 1. The asset is sold for a price > BVt „ Assume an asset was originally purchased
„ SP > BVt generates a tax liability for $10,000, 3 years ago.
„ Assume the current book value for tax
2. The asset is sold for a price = BVt
purposes is $3000.
$3000.
„ SP = BVt no tax liability generated
„ We will apply three different hypothetical
3. The asset is sold for a price < BVt selling prices to see the various tax
„ SP < BVt generates a tax savings implications due to disposal.
„ Assume a tax rate of 34% applies.
„ Assume a tax rate – Te applies.

Disposal – 3 Outcomes Disposal Example

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„ Assume SP = $4,000.
B
„ BV = $3,000. Depreciated Portions from
which tax savings
„ Compute (SP – BV) = (4,000 – 3000). Have resulted
„ Equals +$1,000.
+$1,000. (Recaptured Depressiasion)
Depressiasion)
„ Gain on Disposal.
Disposal. Current
Book
„ Tax Rule: Treated as ordinary income to Value
Undepreciated Amount
the firm and taxed at the tax rate. SV = 0
(Investment remaining to be
Recovered)
„ Tax: $1000(0.34) = $340.00
„ NCFsale = $1000 – 340 = $660

Disposal: SP > BVtime of sale RD Cases Illustrated

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 B Recaptured Depreciation „ Assume SP = $3,000.
Remaining Book value „ Compute (SP – BV) = (3000 – 3000) =0
„ No gain or loss on sale;
Sales Price > BV „ No tax implications!
Current SP > BV
Book „ NCFSale = $3,000.
Value
Amt. “over-depreciated: „ When asset is disposed of for it’
it’s current
Recaptured as Ordinary Income:
SV = 0 Taxed @ Ord. Tax Rate book value there is no recaptured
RD Amt depreciation and no tax.

RD: SP > BV@ Disposal 53

Disposal: SP = BVTime of Sale 54
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„ Assume SP = $2,000; „ Tax: (-

(-1000)(0.34) = -$340.00
„ BV = $3000 „ Form of a negative tax!
„ Compute: (SP – BV) = (2000 – 3000) = „ NCF = SP – Tax;
¾ -$1,000. „ NCF = $2,000 – (-340) = $2,340!
¾ “Minus”
Minus” means “loss on disposal”
disposal” „ Treat the tax savings on the loss on
„ The loss can be treated as a negative ordinary disposal as a positive cash flow.
income and deducted.
„ Assume tax deductibility of the loss
„ Tax: (-
(-1000)(0.34) = -$340.00
amount which generates a tax savings.
„ Form of a negative tax!

Disposal: SP < BVTime of Sale

Disposal: SP = BVTime of Sale 55 56
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 „ What if the SP is greater than the original
Asset is disposed at below the
B book value creating a loss on
basis of the asset? (rare for productive assets)
disposal. „ Assume SP = $12,000;
„ B = $10,000.
Creates a “loss” on disposal and
is treated as a deduction—tax „ BVtime of sale = $3,000
Current
Book savings. „ Two Components to deal with:
Value
Sale Price less than BV „ (SP – B) = 12,000 – 10,000 = $2,000
SV = 0 „ Called the “Gain”
Gain” amount
Loss On
Disposal

RD: SP < BV@ Disposal Disposal: 4th Situation: SP > B

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„ 2nd Component:
„B – BVTime of Sale „ Tax the Recaptured Depreciation amount of
„ $10,000 - $3,000 = $7,000 $7,000 at the ordinary income tax rate of
34%.
„ Tax Situation for Economy Studies
„ The RD amount is treated as ordinary income.
„ Tax the “gain”
gain” part at either 34% or,
whatever the current capital gain tax rate is „ Possible Tax Evaluation assuming the “gain”
gain”
at the time (28%) on gains. part is taxed at 28% and RD at 34%

Disposal: 4th Situation: SP > B Disposal: 4th Situation: SP > B

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 Possible Tax Evaluation assuming the “gain” „ Assume case 1:
„ gain”
„ SP = $4000;
part is taxed at 28% and RD at 34%
„ BV = $3000

„ Gain: $2000(0.28) = $560. „ Asset is sold for more than it’

it’s current
„ RD: $7000(0.34) = $2380 book value.
„ Total Tax: $2940 „ The depreciation plan specified that the
book value is now $3,000.
„ NCF – sale: $12,000 - $2,940 = $9,060
„ But a market value is now set at $4000.
„ (willing buyer and willing seller agreement)

Disposal: 4th Situation: SP > B Recaptured Depreciation ( RD )

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„ From the tax view: „ To treat as ordinary income and pay a tax
on that amount.
„ The asset brought more that it’
it’s current
„ Any time an asset is disposed of for an
book value.
amount that exceeds the current book
„ Implication: That the firm over-
over-depreciated
value for tax purposes,
the asset by $1,000 (but not intentionally!)
„ The amount in excess of the current book
„ The Tax code treats the $1000 as ordinary
value is treated as ordinary income and
income or, recaptured deprecation and
taxed as such.
taxes it at 34%

RD - Explained To Recapture Means…

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„ Recall, MACRS assumes a “0” salvage
value for fully depreciated assets.
„ What if an asset is fully depreciated,?
„ Under MACRS the book value at the time
Under current Federal tax law:
Any depreciable asset that is disposed of during
the recovery period requires the following:
1. Only ½ year of the normal depreciation is permitted
in the year of disposal.
2. Assumption: Disposal occurs at the middle of the

of disposal will be 0. year in question.

3. The beginning of year book value is reduced by the
„ IF SP > 0 then the SP amount is also
½ year of recovery to establish the BV for tax
taxed at the ordinary tax rate! purposes.

“0” Salvage Value Issue Disposal During the Recovery Period

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„ Now, the book value for tax purposes is:

„ Assume an asset is in it’
it’s 4-
4-th year of recovery
and is sold (disposed). „ Beginning of year’
year’s BV3 = $5,000,
„ Assume the beginning of year book value is „ Less the $1,000 of permitted recovery due to the
$5000. half-
half-year rule on disposal or, $4,000.
$4,000.
„ Assume the 4th year’
year’s total recovery – if not
disposed – would be $2000. „ The sale price, SP is now compared to the
„ Only ½ year of recovery is permitted for year 4 $4,000 BV@ Time of Sale to determine if there
or ½(2000) = $1,000. is any recaptured depreciation.

Disposal During Recovery Year 67

Disposal Example: Continued 68
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 „ Assume disposal anytime during year “t” „ We now expand the TI expression to
where “t” is less than or equal to the accommodate depreciation recapture
MACRS recovery period for the asset. amounts.
Mid-Year

No Depr. Permitted
Year”t”
B.O.Y.-t E.O.Y.-t TI = GI – E – D +DR + CG – CL [14]

However, the firm is eligible for ½ of the

Current year’s MACRS depreciation regardless Applicable only to corporations and not to individuals!
When disposal actually took place in the year.

Depreciation Recapture Concluded

Half-year Rule for Disposal 69 70
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AFTER-TAX PRESENT WORTH,

ANNUAL WORTH, AND ROR
EVALUATION

Summary for Disposal Analysis

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 „ Assuming the analyst has estimated all „ Single Project:
relevant cash flows and conducted an „ PW or AW > 0 at i% or,
ATCF analysis the economic desirability of „ IROR > i%.
the cash flow can be determined.
„ All techniques previously presented can be „ Two or More Alternatives:
used, e.g., „ Select the alternative with the largest PW or
„ Present Worth, AW value at the i% rate.
„ Future Worth, „ If using IROR, must apply the incremental
„ Annual Worth, analysis approach.
„ IROR, . . .

Single Project or Multiple Alternatives

After-tax Cash Flow Evaluation 73 74
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„ Some firms may set a before-

before-tax discount
„ All previous rules apply:
„ For PW – equal lives
rate – MARRB.T..
„ For AW – repeatability assumption applies „ For after-
after-tax analysis, the before-
before-tax MARR
„ Some ATCF problems involve only costs. must be adjusted by applying:
„ MARRAfter- = MARRBefore Tax(1-
(1-Te)
„ Calculate the after-
after-tax savings generated After-Tax

by operating expenses and depreciation „ The Before-

Before-tax MARR given the After-
After-tax
and attach a positive sign to the savings. MARR is:
„ MARRBefore Tax = (MARR
(MARRAfter Tax)/(1-
)/(1-Te)

Analysis Techniques After-tax Discount Rate

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 „ Given two or more ATCF alternatives:
„ All previously described analysis methods
„ Rank based upon time t = 0 investment;
can apply to the evaluation of an after-
after-tax
„ Perform the pair-
pair-wise analysis to determine cash flow.
a current champion;
„ Unlike previous chapters, where the cash
„ Complete the pair-
pair-wise analysis until all flow was provided, one must first
alternative have been evaluated. construct the ATCF from a problem
„ Can perform a breakeven analysis by specification – then apply the analysis
plotting PW vs. i approaches.

Mutually Exclusive ATCF Analysis:

IROR Bottom Line
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„ Two ATCF alternatives;

„ Incremental RoR method is presented;
„ A plot of the two methods for discount
rates varying from 5% to 9% is also
SPREADSHEET APPLICATIONS shown;
– AFTER-TAX INCREMENTAL
ROR ANALYSIS

Example :
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 „ A breakeven interest rate equal to 6.35%
is determined;
„ The two alternatives are identical at
6.35% after-
after-tax MARR.

Example :
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The interest rate

at
Which the two
Alternatives are
Economically
Equal (6.36%)

Breakeven Point 83
Example Disposal Concerns 84
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 „ Always beware of using the ROR method
for selecting from among alternatives.
„ DO NOT use computed ROR!
„ Thismeans the ROR computed on each
separate investment alternative.
„ Rather, form the incremental cash flow and
make a determination on the 'i* value. AFTER-TAX REPLACEMENT
„ Need to design a spreadsheet model to STUDY
effectively evaluate.

Using ROR for ATCF Analysis

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Replacement: After-Tax „ Defender Asset

„ Assetcurrently in service;
„ Review Chapter 11:
„ May be tax implications by disposing of the
„ This chapter did not consider taxes in the
defender (recaptured depreciation).
analysis.
analysis.
„ The current book value of the defender is
„ To properly evaluate a replacement needed.
type problem, on should always use an
„ Challenger Asset
after-
after-tax approach.
„ The asset that might be purchased or leased
„ Elements such as: to replace the defender.
„ Depreciation and disposal with possible
recaptured depreciation can make a
difference in the analysis.
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Replacement Basics 88
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 „ Defender:
„ Elements than can alter the ATCF vs. a „ Purchased 3 years ago for $600,000.
BTCF analysis for replacement. „ Now, outdated due to advancing
„ Depreciation and the tax savings. technology.
„ Disposal implications of the defender. „ Assume classical straight line has been
„ Recaptured Depreciation or, applied (In reality, MACRS would be
„ Loss on Disposal applied).
„ Half-
Half-year convention for disposal during the life „ Assume a 8-
8-year recovery life applies.
of the defender if it is not fully recovered. „ Annual Operating Costs: $100,000/year
„ Worth $400,000 now!

Building a Model for Replacement ATCF Analysis: Example

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„ First Cost: $1,000,000 „ Assume further that a ESL analysis has

„ Assume straight line depreciation with a 5 year been conducted and the following
life – if purchased. information is available:
„ Annual Operating costs: $15,000/year.
„ For the Defender: ESL from now is 5 more
„ Assume a “0” salvage value at the end of 5 years.
years.
„ For the Challenger: ESL is 5 years.
„ Other Parameters: „ Assume a “0” salvage value for both
„ BT discount rate: 10% alternatives applies.
„ AT discount rate: 7%
„ Effective tax rate: 34%

Challenger Asset Economic Service Life analysis

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 Life 5
Discount Rate 10.00% First 5 columns of the ATCF Worksheet:
(Signed) (+) (+) or (-) Calculated
Def. Time Gross Operating Investment CFBT Tax Rate: 34.00% Discount Rate Atax 7.00%
Age Period Income Expenses or Salvage (1) (2) (3) (4) (5)
CF(Signed) CF(+) CF(+) or (-) Non-CF Intermed. Cal.
3 0 -$400,000 -$400,000
Time Gross Operating Investment Depreciation Taxable
4 1 $100,000 -$100,000
Period Income Expenses or Salvage Amt (+) values Income (TI)
5 2 $100,000 -$100,000
0 $0 $0 -$400,000
6 3 $100,000 -$100,000
1 $0 $100,000 $0 $75,000 -$175,000
7 4 $100,000 -$100,000
2 $0 $100,000 $0 $75,000 -$175,000
8 5 $100,000 $0 -$100,000
3 $0 $100,000 $0 $75,000 -$175,000
$0 $500,000 -$400,000 -$900,000 4 $0 $100,000 $0 $75,000 -$175,000
NPV Amt -779,079 5 $0 $100,000 $0 $75,000 -$175,000
IROR #NUM! $0 $500,000 -$400,000 $375,000
A. Worth -205,519

Before-Tax Cash Flow Analysis for Defender

A. Cost to Retain: $205,519/year for 5 years at 10%.

BTCF – Defender if Retained 5 years 93

ATCF: Defender Asset 94
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(6) (7)
First five columns of the ATCF worksheet for Challenger
(-) C.F Calculated CF
Tax Rate: 34.00% Discount Rate Atax 7.00%
Taxes CFAT t (1) (2) (3) (4) (5)
Ann. Cost CF(Signed) CF(+) CF(+) or (-) Non-CF Intermed. Cal.
-$400,000 0 Time Gross Operating Investment Depreciation Taxable
to retain Period Income Expenses or Salvage Amt (+) values Income (TI)
-$59,500 -$40,500 1 0 $0 $0 -$1,000,000 $25,000
the
-$59,500 -$40,500 2 1 $0 $15,000 $0 $200,000 -$215,000
defender 2 $0 $15,000 $0 $200,000 -$215,000
-$59,500 -$40,500 3 3 $0 $15,000 $0 $200,000 -$215,000
– After-
-$59,500 -$40,500 4 4 $0 $15,000 $0 $200,000 -$215,000
tax 5 $0 $15,000 $0 $200,000 -$215,000
-$59,500 -$40,500 5
analysis. $0 $75,000 -$1,000,000 $1,000,000
-$297,500 -$602,500
NPV -$566,058.00
IROR #NUM! Depr. Recapture on defender trade in
Ann Worth -$138,056

Last Columns: ATCF Retain Defender Challenger: After-Tax

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 „ Defender’
Defender’s book value at the end of year 3: „ If the defender were retained, then no tax
„ $600,000 – 3($75,000) = $375,000.
$375,000. liability (no recaptured depreciation).
„ Assume Defender is sold for $400,000. „ If the decision to replace is made,

„ SP > BV at time of sale; ordinary income amount of $25,000 (gain

„ Compute: (SP – BV);
„ (400,000 – 375,000) = +25,000.
„ Treated as Ordinary Income
„ Tax: ($25,000)(0.34) = $8,500.
on sale) is assigned to the challenger!
„ Because going with the challenger would
trigger the recaptured depreciation
amount.

Defender Recaptured Depreciation

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Tax on Recaptured Depreciation 98
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(6) (7)
(-) C.F Calculated CF • If Defender is retained:
Taxes CFAT t
•BTCF annual cost: $205,520/year
$8,500 -$1,008,500 0 Annual cost if
-$73,100 $58,100 1 The challenger •ATCF annual cost: $138,056/year
-$73,100 $58,100 2 Is
-$73,100 $58,100 3 Purchased • If the Challenger is purchased:
-$73,100 $58,100 4 Is $187,864/yr.
-$73,100 $58,100 5 •BTCF annual cost: $278,800/year
-$365,500 -$718,000
NPV -$770,278.53 •ATCF annual cost: $187,864/year
IROR #NUM! Retain Defender for 5 more years: Reevaluate in one
Ann Worth -$187,864 year if the estimates change.

Challenger ATCF – if purchased. Example Summary

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 „ The last example specified straight line
recovery;
„ Typically, MACRS would be used;
„ For the defender, only a ½ year of recovery
would be permitted.
„ Thus, all ATCF values would be different AFTER-TAX VALUE
than what has been shown. ADDED ANALYSIS

Technical Note
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Value added is a term to indicate

that a product or a service:
„ Has added value to the consumer or buyer.
„ Popular concept in Europe;
„ Value-
Value-added taxes are imposed in Europe on
certain products and paid to the government.
„ You go and buy onions at a market;
„ Pay from 25 to 50 cents a pound for the onions;
„ You like onion rings so:
„ Onion rings require that onions be purchased,
chopped, and fried;
„ You buy onion rings for say $1.78/pound;
„ Much higher that raw onions!

VALUE ADDED VALUE ADDED: Example

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 „ Why do you pay $1.78/pound for onion
rings and only say 30 cents a pound for raw
onions?
„ Because of the processing costs associated
with transforming raw onions into onion
rings!
„ Value (cost) is added due to the processing
costs and different packaging.
„ Rule:
„ The decision concerning an economic
alternative will be the same for a value
added analysis and a CFAT analysis.
„ Because, the AW of economic value
added estimates is the same as the AW
and CFAT estimates!

VALUE ADDED: Example VALUE ADDED

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„ EVA indicates the project’

project’s contribution to
„ To start, Apply Eq. 3:
the net profit of the corporation after taxes
„ NPAT = Taxable Income – taxes
have been paid.
„ NPAT = (TI)(1-
(TI)(1-T) „ The cost of invested capital is normally the
„ Value added or Economic Value Added ( EVA) firm’
firm’s after-
after-tax required MARR value.
is: „ One multiplies the AT-
AT-MARR by the current
„ The amount of NPAT remaining after removing level of capital (investment).
the cost of invested capital during the time
period in question. „ Charge interest on the unrecovered capital
investment at the AT-AT-MARR rate.

VALUE ADDED: Starting Point EVA - Explained

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 „ Two Alternatives, A and B
„ Recall, firms often have two sets of books „ A Which alternative
relating to depreciation: is preferred using EVA?
„4 year life
„ One for tax purposes and,
„ P = -$500,000 with a “0” salvage value
„ One for internal management use. (book
„ GI – E = $170,000/yr
depreciation).
„ For EVA, book depreciation is more often
„ B
used.
used. „4 year life
„ More closely represent the true rate of usage of „ P = $1,200,000 with “0” salvage value
the assets in question.
„ GI – E = {$600,000 decreasing by $50,000/yr}

EVA and Invested Capital MARR = 12% (A.T), n = 4, Te = 40%

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EVA – Example 110

Plan A (1) (2) (3) (4) (5) (6) (7)

End of GI - Investment Depreciation Book Taxable Taxes Net Profit
Period Exp P Value Income Owed After Tax
0 -$500,000 $500,000 $0 $0
n= 4 1 $170,000 $125,000 $375,000 $45,000 $18,000 $27,000
MARR = 12.0% 2 $170,000 $125,000 $250,000 $45,000 $18,000 $27,000
3 $170,000 $125,000 $125,000 $45,000 $18,000 $27,000
Tax Rate 40.0%
4 $170,000 $125,000 $0 $45,000 $18,000 $27,000
Sums $680,000 -$500,000 $500,000 $180,000 $72,000 $108,000

Plan B (1) (2) (3) (4) (5) (6) (7)

End of GI - Investment Depreciation Book Taxable Taxes Net Profit
Period Exp P Value Income Owed After Tax
0 -$1,200,000 $1,200,000 $0 $0
1 $600,000 $300,000 $900,000 $300,000 $120,000 $180,000
2 $500,000 $300,000 $600,000 $200,000 $80,000 $120,000
3 $400,000 $300,000 $300,000 $100,000 $40,000 $60,000
4 $300,000 $300,000 $0 $0 $0 $0
Sums $1,800,000 -$1,200,000 $1,200,000 $600,000 $240,000 $360,000

Example Spreadsheet Model Base Calculations: Plan A and B

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 (8) (9) (10) (8) (9) (10)
Cost of EVA Cost of EVA
Invest. Capital NPAT-CoIC t CFAT Invest. Capital NPAT-CoIC t CFAT
$0 0 -$500,000 $0 0 -$1,200,000
$60,000 -$33,000 1 $152,000 $144,000 $36,000 1 $480,000
$45,000 -$18,000 2 $152,000 $108,000 $12,000 2 $420,000
$30,000 -$3,000 3 $152,000 $72,000 -$12,000 3 $360,000
$15,000 $12,000 4 $152,000 $36,000 -$36,000 4 $300,000
$150,000 -$42,000 $108,000 $360,000 $0 $360,000
PW of EVA -$38,323 PW -$38,323 PW of EVA $10,289 PW $10,289
AW of EVA -$12,617 RoR 8.31% AW of EVA $3,388 RoR 12.44%
AW -$12,617 AW $3,388

EVA Components EVA-CFAT for A EVA Components EVA-CFAT for B

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(9) (10) (9) (10) Summary Values for A

EVA EVA
NPAT-CoIC t CFAT NPAT-CoIC t CFAT PW of EVA -$38,323 PW -$38,323
$0 0 -$500,000 $0 0 -$1,200,000
-$33,000 1 $152,000 $36,000 1 $480,000
AW of EVA -$12,617 RoR 8.31%
-$18,000 2 $152,000 $12,000 2 $420,000 AW -$12,617
-$3,000 3 $152,000 -$12,000 3 $360,000
$12,000 4 $152,000 -$36,000 4 $300,000
-$42,000 $108,000 $0 $360,000 Summary Values for B
-$38,323 PW -$38,323 $10,289 PW $10,289
-$12,617 RoR 8.31% $3,388 RoR 12.44% PW of EVA $10,289 PW $10,289
AW -$12,617 AW $3,388 AW of EVA $3,388 RoR 12.44%
AW $3,388
EVA-CFAT: A EVA-CFAT: B
“B” is the preferred option!

EVA Comparisons: A vs. B

EVA and CFAT for A and B 115 116
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 „ Note, the AW(12%) of the EVA and the „ EVA values represent an alternative’
alternative’s periodic
CFAT is the same. contribution to the value of the corporation or
firm:
„ Although the values that make up the
„ The CFAT values represent the actual cash
EVA column and the values that make
flows – after tax –into the corporation or firm.
up the CFAT are different,
„ Corporate executives generally prefer to view
„ Their annual worth’
worth’s at 12% are identical. the EVA values;
„ Engineers will tend to compute the CFAT
values.

What does EVA Mean? Meaning of EVA and CFAT

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„ For the $500,000 investment in A the

„ For both options, a time t = 0 depreciable
capital recovery amount is:
investment is required.
„ $500,000(A/P,12%,4) = $164,617/year over 4
years with a “0” salvage value assumed. „ This investment is recovered over 4 years

„ This amount is “charged”

charged” against the cash
inflows for each year for alternative A.
(written off for tax purposes).
„ There remains an unrecovered investment
at the beginning of each year.
„ The owner’
owner’s for the firm expect to earn
interest on the unrecovered investment.

EVA and Capital Recovery A Second Point To Consider

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„ For EVA, the undepreciated investment at
the beginning of a time period is multiplied
by the MARR.
„ This calculates interest on the
undepreciated (unrecovered) investment.
„ These amounts are treated as a cost and
charged against the income flows.
„ AW of EVA and,
„ AW of CFAT:
„ Are identical in amount.
„ Either method can be applied.
applied.
„ EVA describes added worth or value to
the firm for the project;
„ CFAT describes the timing (how) the
funds will flow into the corporation.

Undepreciated (unrecovered) Investment EVA vs. CFAT

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„ After-
After-tax analysis does not usually change „ The-
The-after-
after-tax MARR is used in all PW
the decision to select one alternative over and AW computations, and in deciding
another. between two or more alternatives using
„ ATCF does offer a much clearer estimate of incremental RoR analysis.
the monetary impact of taxes. „ Generally the firm will apply two interest
„ After-
After-tax PW AW, and ROR evaluations of rates:
one or more alternatives are performed on „ MARR value for before-
before-tax analysis;
the CFAT series: using exactly the same „ MARR value for after-
after-tax analysis.
procedures as n previous chapters.

Summary
123
Summary 124
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 „ Income tax rates for U.S. corporations and „ In computing taxable income, permissible
individual taxpayers are graduated-
graduated-higher non-
non-cash flow amounts can be applied to
taxable incomes pay higher income taxes. moderate TI:
„ A single-
single-value, effective tax rate Te is usually „ Depreciation amounts,
applied in an after-
after-tax economic analysis. „ Depletion amounts,

„ Taxes are reduced because of tax- tax-deductible „ Amortization amounts.

items: „ For CFAT analysis, depreciation and

„ depreciationand, depletions amounts must be considered as
„ operating expenses.
expenses. part of the analysis.

Summary Summary
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„Taxable Income (TI):

„ Key general cash flow after-after-tax
relations for each year are:
„ CFBT = gross income - expenses - initial
investment + salvage value .
„ CFAT = CFBT - taxes = CFBT - (taxable
income)(Te).
TI = gross income - expenses - depreciation
+ depreciation recapture
„ If an alternative's estimated
contribution to corporate financial
worth is the economic measure:
the economic value added (EVA) should be
determined. Unlike CFAT, the EVA
includes the effect of depreciation.

Summary Summary
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 „ Economic Value Added is:
„ Economic Value Added is:
„ EVA = net profit after taxes - cost of invested
capital „ EVA = net profit after taxes - cost of
„ = NPAT - (after-
(after-tax MARR)(book value) = TI-TI- invested capital.
taxes - i(BV)
„ EVA =
„ The equivalent annual worths of CFAT and EVA
„ NPAT - (after-
(after-tax MARR)(book value)
estimates are the same numerically, due to the
fact that they interpret the annual cost of the „ NPAT = TI - taxes - i(BV)
capital investment in different, but equivalent „ EVA analysis is often preferred by
manners.
corporate executives as opposed to CFAT.

Summary Summary
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In a replacement study,
study, the tax impact of: The tax analysis may or may not reverse
„ depreciation recapture or the decision to replace or retain the
„ capital loss,
loss, defender:
„ either of which may occur when: But the effect of taxes will likely
„ the defender is traded for the challenger and, reduce (possibly by a significant
„ Must be accounted for in an after-
after-tax analysis. amount) the economic advantage of
one alternative over the other.

Summary Summary
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 End

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