BTCF-ATCF

Table: U.S. Tax Depreciation Allowed for Various

MACRS Asset Classes.

2
 Corporate Tax Rates
Income tax for corporations is computed in a manner similar to that for individuals.
.
If taxable income is over but not over tax is of the amount
over
0 50,000 0 + 15% $0
50,000 75,000 7,500 + 25% 50,000
75,000 100,000 13,750 + 34% 75,000
100,000 335,000 22,250 + 39% 100,000
335,000 10 million 113,900 + 34% 335,000
10 million 15 million 3,400,000 + 35% 10 million
15 million 18,333,333 5,159,000 + 38% 15 million
>=18,333,333 6,425,667 + 35% 18,333,333

Note the bracket with a 39% rate between two brackets with 34% rates. (The 5%
surtax is to phase out prior tax benefits.)

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 Economic Analysis Before and After Taxes
Example. Giuliano’s Pizza plans to spend $3,000 on a truck for the shipping and receiving
department of its local warehouse. Estimated life = 5 years, Estimated savings per year
= $800
Estimated salvage value = $750. Giuliano’s is in the 34% tax bracket.
SL depreciation = (3000-750)/5 = $450 per year.

Year CF before taxes SL Depr. Taxable Inc. Tax (34%) CF after taxes
(a) (b) (c) = (a) – (b) (d) = 34%(c) (a) - (d)
0 -$3,000 -$3,000
1 800 450 350 119 681
2 800 450 350 119 681
3 800 450 350 119 681
4 800 450 350 119 681
5 800 + 750 450 350 119 681 + 750

Before Taxes: CFS (a) has IRR = 15.69% After Taxes: CFS (e) has IRR = 10.55% 4
 After-tax economic analysis is
generally the same as before-tax
analysis, just using after-tax cash
flows (ATCF) instead of before-
tax cash flows (BTCF). The ATCF
analysis is conducted using the
after-tax MARR.
 Taking taxes into account changes
our expectations of returns on
projects, so our MARR (after-tax) is
lower.
 Economic Analysis Before and After Taxes
After-tax analysis is what is most important.
Income taxes are a major disbursement that cannot be ignored.

Example
A firm is losing sales because it cannot always make quick deliveries.
By investing an extra $20,000 in inventory it is believed that the before-tax profit of the
firm will be $1,000 more the first year. The second year before-tax extra profit will be
$1,500.
The extra profit is then expected to go up $500 more each year. The investment in extra
inventory may be recovered at the end of a four-year analysis period by selling it and not
replenishing the inventory.
Assume the incremental tax rate is 39%.
We wish to find the ROR before taxes, and the ROR after taxes.

Important:
Inventory is not considered a depreciable asset.
The investment in extra inventory is not depreciated.
(Even though an old inventory may have less value to the owner, the tax code does not
recognize this.)
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 Economic Analysis Before and After Taxes

Year CF before SL Taxable Inc. Tax (39%) CF after

taxes Depr. taxes
(a) (b) (c) = (a) – (b) (d) = 39%(c) (a) - (d)
0 -$20,000 -$20,000
1 1,000 0 1,000 390 610
2 1,500 0 1,500 585 915
3 2,000 0 2,000 780 1,220
4 2,500 + 20,000 0 2,500 975 1,525 +
20,000

Before taxes: CFS (a) has IRR = 8.50%

After taxes: CFS (e) has IRR = 5.24%.

Key point: inventory is not considered a depreciable asset, even though its
value to the owner may decrease over time.
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Cash flows are typically determined for
each year using the notation below.
Rk = revenues (and savings) from the project
during period k
Ek = cash outflows during k for deductible
expenses
dk = sum of all noncash, or book, costs
during k, such as depreciation
t = effective income tax rate on ordinary
income
Tk = income tax consequence during year k
ATCFk = ATCF from the project during year k
 Some important cash flow formulas.
Taxable income

Ordinary income tax consequences

Example:

Acme purchased a pump for $250,000 and

expended $20,000 for shipping and installation.
The addition of this pump will result in an increase
in revenue of $80,000, with associated increased
expenses of $10,000, each year. The pump has a
GDS recovery period of five years, and Acme’s
effective tax rate is 41%. What is the ATCF for this
project for the fourth year of service of the asset?
 with GDS MACRS 5-year
Periods Before Tax Depreciation Taxable Income Tax After Tax
Cash Flow (41% bracket) Cash Flow
= BTCF - TAx
0 -270,000 -270,000

1 70,000 20% of B 70,000 – 54,000 = 6,560 63,440

= 54,000 16,000
2 70,000 32% of B

3 70,000

4 70,000 31,104 38,896 15,947 54,043

5 70,000 31,104 15,947 54,043

6 70,000 5.76% of B

• At the end of period 6, Book Value= 0

 Example: Should we invest?
• New Machine:
– Investment = $11,000
– Tax Life and Actual Life = 5 years
– Tax Salvage and Actual Salvage = $1,000
– Income = $4,000 per year
– Operating Expenses = $1,000 per year
– 40% Tax Rate
– After Tax MARR = 9%
 with MACRS 3-year
Periods Before Tax Depreciat ion Taxable Tax Aft er Tax
Cash Flow Income Cash Flow
0 -11 00 0 -11 00 0

1 30 00 36 66. 6 7 -66 6.3 0 -26 6.5 2 32 66. 5 2

2 30 00 48 88. 8 9 -18 89. 5 0 -75 5.8 0 37 55. 8 0

3 30 00 16 29. 1 0 13 70. 9 0 54 8.3 6 24 51. 6 4

4 30 00 81 5.1 0 21 84. 9 0 87 3.9 6 21 26. 0 4

5 30 00 0 30 00 12 00 18 00

5 10 00 10 00 40 0 60 0
Salvage

• At the end of period 5, Book Value= 0

 Economic Analysis for MACRS 3-year

• Before-tax NPW
= -11000 + 3000 (P/A, 0.09, 5) + 1000 (P/F, 0.09, 5)
= 1319
• After-tax NPW
= -11000 + 3266.52 (P/F, 0.09, 1) + 3755.8 (P/F, 0.09, 2)
+ … + (1800+600) (P/F, 0.09, 5)
= 117
• Before-tax ROR = 13.34%
• After-tax ROR = 9.45%
 with MACRS 5-year
Periods Before Tax Depreciation Taxable Income Tax After Tax
Cash Flow Cash Flow
0 -11000 -11000

1 3000 2200.00 800.00 320.00 2680.00

2 3000 3520.00 -520.00 -208.00 3208.00

3 3000 2112.00 888.00 355.20 2644.80

4 3000 1267.20 1732.80 693.12 2306.88

5 3000 633.60 2366.40 946.56 2053.44

5 1000 -267.20 -106.88 1106.88

Salvage

• At the end of year 5, Book Value = 11,000 - 2200 -

3520 - 2112 - 1267.2 - 633.6 = 1267.2
 Economic Analysis for MACRS 5-year
• After tax NPW = -110
• After tax ROR = 8.61%