Engineering Economic AnalysisCanadian Edition

Chapter 12:

After-Tax Cash Flows

12-2

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.

12-3

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.

12-4

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.

12-5

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.).

12-6

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.

12-7

Corporate Income Taxes …Income Statement

for TMU Corporationfor the year ending December 31, 2007

Operating revenues ORLess: Operating costs OCBefore-tax cash flow (BTCF) OR OC CCA CCA Debt interest ITaxable income OR OC CCA ILess: income taxes (rate T) T(OR OC CCA I)Net Profit (loss) (OROCCCAI)(1T)

12-8

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.).

12-9

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).

12-10

Accounting & Eng’g Economy … After-tax cash flow (ATCF):

= Net profit + CCA + Debt interest (I)

= (Taxable income)(1T) + 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)(1T) + I(T) + CCA(T) I DIV

= (OR OC I)(1T) + CCA(T) DIV

= Net profit + CCA DIV

12-11

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

12-12

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 = TCCA, called the CCA tax shield.

CCA (depreciation) is added to the net profit to get the net after-tax cash flow.

12-13

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.

12-14

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(BdS).

S = Salvage value (before-tax proceeds from disposal)

T = marginal tax rate

Bd = Book value at disposal (UCC)

12-15

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.

rate discount i

ratetax marginal sfirm’ T

class asset specified the for rateCCA d

basis) (cost asset of cost capital B

1

211

C

i

i

di

dTB C

12-16

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).

disposal) of (year lifetime N

earlier defined as i ,T ,d

value salvage S

1

11

C

N

C

idi

dTS

12-17

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.

12-18

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.

12-19

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(1T)

• 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(1T) is a reasonable approximation under some circumstances.

12-20

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 …)

12-21

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.

12-22

Comprehensive Example …Purchase cost per truck : $67,500Salvage value per truck : $5,000

Number of trucks: 20Annual net revenue per truck : $20,750

Annual maintenance charge per truck : $1,550Fixed costs: $35,000

Work ing capital per truck : $7,500CCA rate: 30%Tax rate: 37.5%

MARR: 12.75%Planned lifetime (years): 8

Truck purchase -$1,350,000.00PV(CCA tax shield gained) $335,176.22

Investment in work ing capital -$150,000.00PV(Salvage) $38,288.43

PV(CCA tax shield lost on salvage) -$10,075.90PV(recovered work ing capital) $57,432.65

PV(net after-tax operating cash flow) $1,055,751.80

NPV= -$23,426.80IRR= 12.300%

Johnston Forwarding Inc. should not invest in the trucks.

12-23

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.