ENGR 3360U Winter 2014 Unit 12: After-Tax Cash Flow

ENGR 3360U Winter 2014
Unit 12
After-Tax Cash Flow
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01
Unit 12 After-Tax Cash Flow
Change Record
2014-I-01 Initial Creation
Text reference Chapter 12
12-2
2014-I-01
Dr. J. M. Bennett P.Eng., PMP ENGR 3360
Course Outline
12-3
0 Macro-Micro Eco
2 Eng Estimation
3-4 Interest and Equivalence
5 Present Worth
6 Annual Cash Flow
7 Rate of Return
8 Choosing the Best Alternative
9 Other Analyses
10 Risk and Uncertainty
2014-I-01
11 Depreciation
12 After-Tax Cash Flow
13 Replacement Analysis
14 Inflation
15 MARR Selection
16 Public Sector Issues
17 Accounting
18 Business Plans
19 Summary
Unit 12 Road Map

12.1 Definitions
12.2 Net Cash Flow
12.3 Cash Flow After-tax (CFAT)
12.4 Replacement After-tax
12.5 Value-added
12-4
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12.1 Important terms: Gross Income

Gross Income
Total income for the tax year from all revenue
producing function of the enterprise.
Sales revenues,
Fees,
Rent,
Royalties,
Sale of assets
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12.1 Income Tax

The total amount of money transferred
from the enterprise to the various taxing
agencies for a given tax year.
Corporate Taxes are normally paid monthly and
a final adjusting payment is submitted with the
annual tax return.
This tax is based upon the income producing
power of the firm.
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12.1 Operating Expenses (E)

All legally recognized costs associated with
doing business for the tax year.
Real Cash Flows,
Tax-deductible expenses for corporations,
Wages and salaries,
Utilities,
Other taxes
Material expenses
AOC and M&O costs are applicable here
Gross Income expenses = GI - E

12-7
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Capital Cost Allowance (CCA)

Portion of the undepreciated capital cost (UCC)
or book value, of a depreciating asset that can be
claimed. Most have the 50% rule applied in the
first year.
CCAn, UCCn, P = initial cost, d = CCA class rate
For year 1, CCA1 = P(d/2)
For year n, CCAn = P(1-d/2)(1-d)n-2
UCCn = P(1-d/2)(1-d)n-1
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12.1 Taxable Income (TI)

Calculated amount of money for a
specified time period from which the tax
liability is determined.
Calculated as:
TI = Gross Income expenses depreciation
TI = GI E CCA
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[12.1]
12.1 Tax Rate T

A percentage or decimal equivalent of TI.
The applicable tax rate depends upon the
total amount of TI.
Taxes owed equals:
Taxes = (taxable income) x (applicable rate)
= (TI)(T).
[12.2]
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12.1 Net Profit After Tax (NPAT)

Amount of money remaining each year
when income taxes are subtracted from
taxable income.
NPAT = TI {(TI)(T)},
= (TI)(1-T).
[12.3]
12-11
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Tax Bases in Canada

Federal, provincial, civic, territorial taxes
Based on income, property, sales, net
capital investment, import tax, product
specific (liquor, hotel, airport)
12-12
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A Sad Story
James Clerk Maxwell, the brilliant English
physicist, was the first to investigate the
properties of electricity. A politician asked
him what the value of this new discovery
would be for the people of England.
Maxwell replied I cannot think of an
application specifically but I am absolutely
sure that you will tax it!
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Canadian Corporate Tax Rate

Not tied to income (like personal tax)
Base rate is 22.1% + 16% = 38% but many exceptions abound
(provies vary from 8.9% (QC) to 16% (PEI, ON is 14%))
Taxable capital < $10,000,000, small business deduction
(SBD) applies: 16% on first $300,000
Federal tax abatement is 10% less (so small firms pay 12%!)
Man and processing rebate of 7% if not eligible for the SBD
Other rebates for resource development, scientific research,
environmental actions, native activities, etc.
Argh! Call in Lawyer Loophole!
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Provincial Taxes too

Range from 8.9 to 16%
CRA collects these for the provinces except
ON, QB, AB
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Effective Tax Rate Te

Te sum of all taxes. Ranges from 13-45%
Te = (total taxes paid)/(taxable income)
Portion of each new dollar of taxable
income is called the marginal tax rate
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Example 12.1
Freshflow is a Canadian-controlled private corporation
in Fredericton, N.B., that manufactures biofilters for
wastewater treatment plants. The company had a gross
income of $900,000 and CCA of $30,000 on their
production machinery. Expenses were
Cost of production = 250,000
Salaries and benefits = 200,000
Other expenses
= 50,000
Total =
$500,000
(a) What amount of tax will the company pay on their
federal and provincial taxable income?
(b) What is the companys effective tax rate?
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Solution to 12.1
(a) Taxable income = gross income - expenses - CCA
TI = $900,000 - 500,000 - 30,000 = $370,000
Federal income tax. Because the company qualifies for the SBD, the first
$300,000 is taxable at a rate of 12% (38% - 16% - 10%).
Taxes = (taxable income)(applicable tax rate)
= ($300,000)(0.12) = $36,000
Freshflow qualifies for the manufacturing and processing profits deduction of
7% on the remainder of the income taxable at the rate of 21% (38% - 10% 7%).
Taxes = ($70,000)(0.21) = $14,700
Total federal tax = $36,000 + 14,700 = $50,700
New Brunswick income tax. In New Brunswick, $500,000 is the business limit
used in calculating the income eligible for the small business rate of 1%. Income
above $500,000 is taxed at a rate of 13%.
Provincial tax payable = ($370,000)(0.01) = $3700
Total combined taxes = 50,700 + 3700 = $54,400
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Freshflows Effective Tax Rate

Te = taxes/TI = 54,400/370,000 = 14.7%
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Personal vs. Corporate

Individuals report total income;
Gross earned income;
However, individuals may not deduct most
of their expenses for day to day living and
working.
Individuals must apply the various standard
or itemized deductions permitted by current
law
Corporations deduct actual cash flow
expenses.
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Personal vs. Corporate

Individual have to file as either:
Single,
Married,
Head of household.
Corporations have no such filing status

other than filing as a corporation.
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Individual Federal Tax Rates

First 36,378
15.5%
Between 36379 and 72,756
22%
Between 72,757 and 118,285
26%
Over 118,286
29%
In Ontario, we pay 50% of the FT.
There are also many tax credits
- pensions, tuition, disability, medical, donations, gifts
12-22
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12.2 NET CASH FLOW - NCF

NCF represents:
Cash Inflow Cash Outflows for a given time
period.
For economy studies the engineer will

estimate the future net cash flows associated
with the project over the estimated life of
the project.
Now, we define Cash Flow Before Tax
(CFBT).
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12.2 Cash Flows Before Tax ( CFBT )

CFBT:
Actual real cash flows associated with an
investment BEFORE any income tax
considerations are applied.
CFBT does not consider depreciation or
depletion amounts.
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12.2 CFBT Defined

CFBT =
Gross income expenses initial investment +
salvage value
CFBT= GI E P + S
[12.7]
Note:
12-25
Depreciation and depletions amounts are not part of

CFBT as they are not real cash flows per se.
2014-I-01
12.2 Cash Flow After Tax ( CFAT)

CFAT for a given time period is defined as:
CFAT = CFBT Taxes.
The Taxes component must be expanded to
include the impacts of depreciation and/or
depletion.
Depreciation is a noncash flow but is
deductible from GI and serves to moderate
(lessen) the TI amount.
12-26
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12.3 After-tax Cash Flow Evaluation

Assuming the analyst has estimated all relevant cash
flows and conducted an ATCF analysis the economic
desirability of the cash flow can be determined.
All techniques previously presented can be used, e.g.,
Present Worth,
Future Worth,
Annual Worth,
IRR, . . .
12-27
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Single or Multiple Alternatives

Single Project:
PW or AW > 0 at i% or,
IRR > i%.
Two or More Alternatives:

Select the alternative with the largest PW or
AW value at the i% rate.
If using IRR, must apply the incremental
analysis approach.
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Analysis Techniques
All previous rules apply:
For PW equal lives
For AW repeatability assumption applies
Some ATCF problems involve only costs.

Calculate the after-tax savings generated by
operating expenses and depreciation and
attach a positive sign to the savings.
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After-tax Discount Rate

Some firms may set a before-tax discount rate
MARRB.T..
For after-tax analysis, the before-tax MARR
must be adjusted by applying:
MARRAfter-Tax = MARRBefore Tax(1-Te)
The Before-tax MARR given the After-tax

MARR is:
MARRBefore Tax = (MARRAfter Tax)/(1-Te)
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12.4 Replacement: After-Tax

Review Chapter 11:
This chapter did not consider taxes in the analysis.
To properly evaluate a replacement type

problem, one should always use an after-tax
approach.
Elements such as:
Depreciation and disposal with possible
recaptured depreciation can make a difference in
the analysis.
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Replacement Basics
Defender Asset
Asset currently in service;
May be tax implications by disposing of the
defender (recaptured depreciation).
The current book value of the defender is
needed.
Challenger Asset
The asset that might be purchased or leased to
replace the defender.
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Building a Model for Replacement

Elements that can alter the ATCF vs. a
BTCF analysis for replacement.
Depreciation and the tax savings.
Disposal implications of the defender.
Recaptured Depreciation or,
Loss on Disposal
Half-year convention for disposal during the life of
the defender if it is not fully recovered.
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12.5 Value Added

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-added taxes are imposed in Europe on
certain products and paid to the government.
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Value Added: Example

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!
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Chapter 12 Summary
After-tax analysis does not usually change
the decision to select one alternative over
another.
ATCF does offer a much clearer estimate of
the monetary impact of taxes.
After-tax PW, AW, and IRR evaluations of
one or more alternatives are performed on
the CFAT series: using exactly the same
procedures as n previous chapters.
12-36
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Chapter 12 Summary cont.

The after-tax MARR is used in all PW and
AW computations, and in deciding between
two or more alternatives using incremental
IRR analysis.
Generally the firm will apply two interest
rates:
MARR value for before-tax analysis;
MARR value for after-tax analysis.
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Income tax rates for individual taxpayers are
graduated-higher taxable incomes pay higher income
taxes. Corporations (CDN) pay a flat tax.
A single-value, effective tax rate Te is usually
applied in an after-tax economic analysis.
Taxes are reduced because of tax-deductible items:
depreciation and,
operating expenses.
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In computing taxable income, permissible
non-cash flow amounts can be applied to
moderate TI:
Depreciation amounts,
Depletion amounts,
Amortization amounts.
For CFAT analysis, depreciation and

depletions amounts must be considered as
part of the analysis.
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Key general cash flow after-tax relations for
each year are:
CFBT = gross income - expenses - initial
investment + salvage value .
CFAT = CFBT - taxes =
12-40
CFBT - (taxable income)(Te).
2014-I-01

Taxable Income (TI):
TI = gross income - expenses depreciation + depreciation recapture
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In a replacement study, the tax impact of:
depreciation recapture or
capital loss,
either of which may occur when:
the defender is traded for the challenger and,
Must be accounted for in an after-tax analysis.
12-42
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The replacement study procedure of chapter
11 is applied.
The tax analysis may or may not reverse the
decision to replace or retain the defender:
But the effect of taxes will likely reduce
(possibly by a significant amount) the
economic advantage of one alternative
over the other.
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This chapter serves to:
Enforce the fact that engineers and managers
must be aware of the current federal tax laws
pertaining to the analysis of industrial projects.
Keeping up with CRA code changes is a
challenging task at best.
Corporations retain tax experts to assist in the
proper interpretations of those elements of the
code that apply to CFAT analysis.
12-44
2014-I-01

ENGR 3360U Winter 2014 Unit 12: After-Tax Cash Flow

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ENGR 3360U Winter 2014

Unit 12 After-Tax Cash Flow

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Unit 12 Road Map

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Important terms: Gross Income

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Income Tax

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Operating Expenses (E)

AOC and M&O costs are applicable here

Gross Income expenses = GI - E

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Capital Cost Allowance (CCA)

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Taxable Income (TI)

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Tax Rate T

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

12.1 Net Profit After Tax (NPAT)

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Tax Bases in Canada

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Canadian Corporate Tax Rate

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Provincial Taxes too

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Effective Tax Rate Te

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Freshflows Effective Tax Rate

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Personal vs. Corporate

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Personal vs. Corporate

Corporations have no such filing status

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow

Individual Federal Tax Rates

Dr. J. M. Bennett P.Eng., PMP ENGR 3360

Unit 12 After-Tax Cash Flow