Blankchapter 17

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ENGINEERING ECONOMY Fifth Edition

Blank and Tarquin
Mc
Graw
Hill
CHAPTER 17
AFTER-TAX ECONOMIC
ANALYSIS
Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

Blank and Tarquin
Mc
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CHAPTER 17
Learning Objectives
17. Learning Objectives

1.
Terminology and Rates
2.
Before- and After-Tax Analysis
3.
Taxes and Depreciation
4.
Depreciation Recapture and Capital Gains
5.
After-Tax Analysis
6.
Spreadsheets
7.
After-tax Replacement
8.
Value-added Analysis

Blank and Tarquin
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CHAPTER 17
17.1
INCOME TAX TERMINOLOGY AND
RELATIONS FOR CORPORATIONS
AND INDIVIDUALS
17.1 Important Terms: Gross Income

Gross Income
Total income for the tax year from all

revenue-producing functions of the
enterprise.
Sales revenues,
Fees,
Rent,
Royalties,
Sale of assets
17.1 Income Tax

The total amount of money transferred
from the enterprise to the various
taxing agencies for a given tax year.
Federal Corporate Taxes are normally paid

at the end of every quarter, and a final
adjusting payment is submitted with the tax
return at the end of the fiscal year.
This tax is based upon the incomeproducing power of the firm.
17.1 Operating Expenses (E)

All legally recognized costs associated
with doing business for the tax year.
Real Cash Flows,

Tax deductible for corporations,
Wages and salaries,
Utilities,
Other taxes,
Material expenses,
Etc.
17.1 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 D
[17.1]
17.1 Tax Rate T

A percentage or decimal equivalent of
TI.
For Federal corporate income tax T is
represented by a series of tax rates.
The applicable tax rate depends upon
the total amount of TI.
Taxes owed equals:
Taxes = (taxable income) x (applicable rate)

= (TI)(T).
[17.2]
17.1 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).
[17.3]
10
17.1 NPAT
Net profits (if positive) represent funds
that are the claim of the owners of the
firm NOT the firm!
NPAT can be:
Saved by the firm,

Reinvested within the firm,
Paid out as dividends to the stockholders,
Some combination of paying dividends and
reinvesting.
11
17.1 Federal Corporate Tax Rates

Corporate Tax Rates:
No one single rate;

Series of graduated rates;
TI is partitioned into up to 8 brackets of
taxable income;
A tax rate is then applied to each bracket of
taxable income and then summed across all
applicable brackets.
See Table 17-1 for the 8 bracket rates.
12
17.1 The Eight Federal Tax Brackets (2002)

Taxable Income
Bracket
1
2
3
4
5
6
7
8
Bracket Min
$0
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
Bracket Max
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
Sky's the limit!
13
17.1 Bracket Tax Rates

Taxable Income
Braket
1
2
3
4
5
6
7
8
Braket Min
$0
$50,000
$75,000
$100,000
$335,000
$10,000,000
$15,000,000
$18,333,333
T - (%)
Brkt. Rate
Bracket Max
0.15
$50,000
0.25
$75,000
0.34
$100,000
0.39
$335,000
0.34
$10,000,000
0.35
$15,000,000
0.38
$18,333,333
0.35
Sky's the limit!
14
17.1 Example:
Assume TI = $200,000.
Determine the Federal tax liability.
1st $50,000 (0.15) = $7,500

($150,000 left)
Next $25,000 (0.25) = $6,250 ($125,000 left)
Next $25,000 (0.34) = $8,500 ($100,000 left)
Now we are in the 4th bracket

Tax all monies between $100,000 to
$335,000 at 34%
Last $100,000 (0.34) = $34,000.

Done!
15
17.1 Total Tax on TI = $200,000

Add the bracket tax amounts:
$7,500
$6,250
$8,500
$34,000
$56,250
Tax as a % of TI:
$56,250/$200,000 = 28.13%
16
17.1 Observations
Each bracket rate is termed a
marginal rate.
Note the bracket rates are:
1.
2.
3.
4.
5.
6.
7.
8.
15%
25%
34%
39%
34%
35%
38%
35%
17
17.1 Marginal Tax Rates

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 brackets tax rate.
18
17.1 Tax Bracket Description

A tax bracket system is termed a
graduated tax 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%.
19
17.1 Observations
Firms with lower TI pay less taxes that
firms with much higher TI.
Arguments now for a 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).
20
17.1 State and Federal

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
21
17.1 Combined Tax Rate

Assume a known state tax rate, then:
Compute:
Effective Tax rate Te as:
Te = state rate + (1 state rate) (Federal

Rate)
State income taxes are deductible

expenses for federal income tax
purposes.
22
17.1 Personal vs. Corporate

Individuals report total income;
Gross earned income;
However, individuals may not deduct
most of their day-to-day living and
working expenses.
Individuals must apply the various
standard or itemized deductions
permitted by current law.
Corporations deduct actual cash-flow
expenses.
23
17.1 Personal vs. Corporate

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

other than filing as a corporation.
24
17.1 Individual Tax Rates

See Table 17-2 on page 547;
Similar bracket design with 5 brackets;
1.
2.
3.
4.
5.
15%
28%
31%
36%
39.6%
See Example 17.2
The bracket amounts depend upon

filing status (Single, Married, Head of
Household).
25

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CHAPTER 17
17.2
BEFORE-TAX AND AFTER-TAX CASH
FLOW
26
17.2 NET CASH FLOW NCF

NCF represents:
Cash Inflow Cash Outflows for a given

time period.
From economy studies the engineer will

estimate the future net cash flows
associated with the project over its
estimated life.
Now, we define Cash Flow Before Tax
(CFBT).
27
17.2 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.
Next, CFBT will be defined.
28
17.2 CFBT Defined

CFBT =
Gross income expenses initial
investment + salvage value
CFBT= GI E P + S
[17.7]
Note:
Depreciation and depletion
amounts are not part of CFBT as
they are not real cash flows per se.
29
17.2 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.
30
17.2 Expanding the CFAT Amount

Specifically:
CFAT = GI E P + S (GI-E-D)(TE)
Note the (GI-E-D)(Te) term.
(GI E D) represent the taxable
income component;
Multiplying (GI E D) by Te
computes the tax on the taxable
income part.
Then the tax is subtracted from the
CFBT to yield the CFAT amounts.
31
17.2 Some Observations

Focus on: (GI E - D).
For some time periods this term could
be negative.
Operating loss, which can generate
a negative tax.
If this is the case, then so be it.
Let the sign take care of itself!
32
17.2 CFBT: Format
A tabular approach is suggested.
Numerous formats exist and no

one single format or design is the
best.
See Table 17-3 and Example 17.3
Suggested tabular format follows.
33
17.2 BTCF Format with Example 17.3

Life
Discount Rate
(Signed)
Time
Gross
Period
Income
0
1
$200,000
2
$200,000
3
$200,000
4
$200,000
5
$200,000
6
$200,000
$1,200,000
6
15.00%
(+)
Operating
Expenses
$90,000
$90,000
$90,000
$90,000
$90,000
$90,000
$540,000
(+) or (-)
Investment
or Salvage
-$550,000
$150,000
-$400,000
NPV Amt
IROR
Calculated
CFBT
-$550,000
$110,000
$110,000
$110,000
$110,000
$110,000
$260,000
$260,000
($68,857.76)
10.751%
34
17.2 ATCF Format: Example 17.3

Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$200,000
2
$200,000
3
$200,000
4
$200,000
5
$200,000
6
$200,000
$1,200,000
35.00% Discount Rate Atax

(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$550,000
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$0
$90,000
$150,000
$540,000
-$400,000
10.00%
(4)
Non-CF
Depreciation
Amt (+) values
$110,000
$176,000
$105,600
$63,360
$63,360
$31,680
$550,000
First four columns are presented..

35
17.2 ATCF Format: Example 17.3

(5)
Intermed. Cal.
Taxable
Income (TI)
$0
-$66,000
$4,400
$46,640
$46,640
$78,320
(6)
(-) C.F
Taxes
(7)
Calculated CF
CFAT
$0
-$23,100
$1,540
$16,324
$16,324
$27,412
$38,500
NPV
IROR
-$550,000
$110,000
$133,100
$108,460
$93,676
$93,676
$232,588
$221,500
-$5,075.14
9.708%
t
0
1
2
3
4
5
6
Last four columns are presented..

36
17.2 ATCF Amounts from Column 7

(7)
Calculated CF
CFAT
-$550,000
$110,000
$133,100
$108,460
$93,676
$93,676
$232,588
$221,500
t
0
1
2
3
4
5
6
These amounts represent

the after-tax cash flow
values for years 06.
The analyst can calculate
PW, FW, AW, IROR, etc.
using the methods in the
previous chapters.
The Goal: Is this
investment acceptable?
37
17.2 ATCF Calculations

Best performed with a spreadsheet
model as shown.
Depreciation amounts can be
calculated in another spreadsheet and
copied (values only) into the ATCF
worksheet.
User inputs besides the CF values are
the discount rate and the tax rate.
38

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CHAPTER 17
17.3
EFFECT ON TAXES OF DIFFERENT
DEPRECIATION METHODS AND
RECOVERY PERIODS
39
17.3 Criteria for Selection

Given two or more depreciation
(recovery) plans and:
Constant single value tax rate;

Same recovery period;
CFBT > depreciation amount for the given
year;
The methods reduce the basis to the same
book value over the same time period.
Compute the PW (i%) of the future tax

savings for each plan.
40
17.3 Multiple Criteria Can Be Used

1. Minimize the present worth at some
i% over n time periods of the tax;
2. Maximize the present worth at some
i% over n time periods of the taxes
saved.
PWTAX is defined by:
n
PWtax (taxes in year t)(P/F,i%,t) or,

t 1
PWtaxes saved Dt (te )( P / F , i %, t )

t 1
41
17.3 Rule:
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.
See Table 17-4!
42
17.3 The Goal!

If the firm is profitable and the TI
amount is > 0, then:
Using a depreciation plan that writes off

more of the asset in the early years is
preferred!
Achieving greater tax savings early on
permits the firm to retain more after-tax
dollars;
Which can be reinvested at or above the
firms MARR!
Promote future wealth maximization!
43
17.3 Comparing Depreciation Plans
44

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CHAPTER 17
17.4
DEPRECIATION RECAPTURE AND
CAPITAL GAINS AND LOSSES FOR
CORPORATIONS
45
17.4 CAPITAL GAIN OR GAIN ON SALE

Firms sell or dispose of assets from
time to time.
Those assets have been fully
depreciated, or are still being
depreciated for tax purposes.
Assets that are disposed do have a
book value.
Could be + or,
Could be 0.
46
17.4 Capital Loss: CL
A capital loss occurs when an

asset is sold for less than its
current book value.
Could generate a tax savings since
the loss could be tax deductible
within certain rules.
CL = BVt - SP
47
17.4 Gain on Sale (Capital Gain)

Gain on Sale is defined as:
GS = Selling Price Current Book Value;
Capital Gain is defined as:
CG = Selling Price First Cost.
Certain Assets will gain value over time

and could be sold for more than what
was originally paid for them.
This will generate a tax liability and tax
will have to be paid!
48
17.4 Sale of Productive Assets

Confine discussion to the disposal of
productive assets.
The term Depreciation Recapture
applies. (DR).
DR = SP BVt
[ 17.12 ]
Three possible outcomes can happen
when a productive asset is disposed at
time t.
49
17.4 Disposal 3 Outcomes
1. The asset is sold for a price > BVt
SP > BVt generates a tax liability
2. The asset is sold for a price = BVt
SP = BVt no tax liability generated
3. The asset is sold for a price < BVt
SP < BVt generates a tax savings
Assume a tax rate Te applies.
50
17.4 Disposal Example

Assume an asset was originally
purchased for $10,000, 3 years ago.
Assume the current book value for tax
purposes is $3,000.
We will apply three different
hypothetical selling prices to see the
various tax implications due to disposal.
Assume a tax rate of 34% applies.
51
17.4 Disposal: SP > BVtime of sale

Assume SP = $4,000.
BV = $3,000.
Compute (SP BV) = (4,000 3000).
Equals +$1,000. (Recaptured Depr.)
Gain on Disposal.
Tax Rule: Treated as ordinary income
to the firm and taxed at the tax rate.
Tax: $1,000 (0.34) = $340.00
NCFsale = $1,000 340 = $660
52
17.4 RD Cases Illustrated
Current
Book
Value
SV = 0
Depreciated portions from

which tax savings
have resulted
Undepreciated amount
(investment remaining to be
recovered)
53
17.4 RD: SP > BV@ Disposal

Recaptured Depreciation
Current
Book
Value
SV = 0
Remaining Book Value
RD Amt
Sales Price > BV

SP > BV
Amt. over-depreciated:
Recaptured as Ordinary Income:
Taxed @ Ord. Tax Rate
54
17.4 Disposal: SP = BVTime of Sale

Assume SP = $3,000.
Compute (SP BV) = (3,000 3,000)
=0
No gain or loss on sale;
No tax implications!
NCFSale = $3,000.
When an asset is disposed of for its
current book value, there is no
recaptured depreciation and no tax.
55
17.4 Disposal: SP < BVTime of Sale

Assume SP = $2,000;
BV = $3,000
Compute: (SP BV) = (2,000 3,000)
= -$1,000.
Minus means loss on disposal
The loss can be treated as negative

ordinary income and deducted.
Tax: (-1,000)(0.34) = -$340.00
Form of a negative tax!
56
17.4 Disposal: SP < BVTime of Sale

Tax: (-1,000)(0.34) = -$340.00
Form of a negative tax!
NCF = SP Tax;
NCF = $2,000 (-340) = $2,340!
Treat the tax savings on the loss on
disposal as a positive cash flow.
Assume tax deductibility of the loss
amount, which generates a tax savings.
57
17.4 RD: SP < BV@ Disposal

Asset is disposed at below the
book value, creating a loss on
disposal.
Current
Book
Value
Creates a loss on disposal and

is treated as a deduction (tax
savings).
Loss On
Disposal
Sale Price less than BV

SV = 0
58
17.4 Disposal: 4th Situation: SP > B

What if the SP is greater than the
original basis of the asset? (rare for
productive assets)
Assume SP = $12,000;
B = $10,000.
BVtime of sale = $3,000
Two Components to deal with:
(SP B) = 12,000 10,000 = $2,000

Called the Gain amount
59

2nd Component:
B BVTime of Sale
$10,000 - $3,000 = $7,000
Tax Situation for Economy Studies
Tax the gain part at either 34%, or

whatever the current capital gain tax rate is
at the time (28%) on gains.
60

Tax the Recaptured Depreciation
amount of $7,000 at the ordinary
income tax rate of 34%.
The RD amount is treated as ordinary
income.
Possible Tax Evaluation assuming the
gain part is taxed at 28% and RD at
34%.
61

Possible Tax Evaluation assuming the
gain part is taxed at 28% and RD at
34%.
Gain: $2,000 (0.28) = $560
RD: $7,000 (0.34) = $2,380
Total Tax:
NCF sale: $12,000 - $2,940 = $9,060
$2,940
62
17.4 Recaptured Depreciation (RD)

Assume case 1:
SP = $4,000;
BV = $3,000
Asset is sold for more than its current

book value.
The depreciation plan specified that the
book value is now $3,000.
But a market value is now set at
$4,000.
(willing buyer and willing seller agreement)
63
17.4 RD Explained
From the tax view:
The asset brought more that its current
book value.
Implication: That the firm overdepreciated the asset by $1,000 (but
not intentionally!)
The Tax code treats the $1,000 as
ordinary income, or recaptured
deprecation, and taxes it at 34%
64
17.4 To Recapture Means

To treat as ordinary income and pay a
tax on that amount.
Any time an asset is disposed of for an
amount that exceeds the current book
value for tax purposes,
The amount in excess of the current
book value is treated as ordinary
income and taxed as such.
65
17.4 0 Salvage Value Issue

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 of disposal will be 0.
IF SP > 0, then the SP amount is also
taxed at the ordinary tax rate!
66
17.4 Disposal During the Recovery Period

Under current Federal tax law:
1.
2.
3.
Any depreciable asset that is disposed of

during the recovery period requires the
following:
Only year of the normal depreciation is
permitted in the year of disposal.
Assumption: Disposal occurs at the middle
of the year in question.
The beginning of year book value is
reduced by the year of recovery to
establish the BV for tax purposes.
67
17.4 Disposal During Recovery Year

Assume an asset is in its 4th year of
recovery and is sold (disposed).
Assume the beginning of year book
value is $5,000.
Assume the 4th years total recovery
if not disposed would be $2,000.
Only year of recovery is permitted
for year 4 or (2,000) = $1,000.
68
17.4 Disposal Example continued

Now, the book value for tax purposes is:
Beginning of years BV3 = $5,000,

Less the $1,000 of permitted recovery due to
the half-year rule on disposal, or $4,000.
The sale price, SP, is now compared to

the $4,000 BV@ Time of Sale to determine if
there is any recaptured depreciation.
69
17.4 Half-Year Rule for Disposal

Assume disposal anytime during year
t where t is less than or equal to the
MACRS recovery period for the asset.
Mid-Year
Year t
No Depr. Permitted
B.O.Y.-t
E.O.Y.-t
However, the firm is eligible for of the
current years MACRS depreciation regardless
of when disposal actually took place in the
year.
70
17.4 Depreciation Recapture Concluded

We now expand the TI expression to
accommodate depreciation recapture
amounts.
TI = GI E D +DR + CG CL
[17.14]
Applicable only to corporations and not to individuals!
71
17.4 Summary for Disposal Analysis
72

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CHAPTER 17
17.5
AFTER-TAX PRESENT WORTH,
ANNUAL WORTH, AND ROR
EVALUATION
73
17.5 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,
IROR, . . .
74
17.5 Single Project or Multiple Alternatives

Single Project:
PW or AW > 0 at i% or,
IROR > i%.
Two or More Alternatives:
Select the alternative with the largest PW or

AW value at the i% rate.
If using IROR, must apply the incremental
analysis approach.
75
17.5 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.
76
17.5 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 aftertax MARR is:
MARRBefore Tax = (MARRAfter Tax)/(1-Te)
77
17.5 Mutually Exclusive ATCF Analysis: IROR

Given two or more ATCF alternatives:
Rank based upon time t = 0
investment;
Perform the pair-wise analysis to
determine a current champion;
Complete the pair-wise analysis until
all alternative have been evaluated.
Can perform a breakeven analysis by
plotting PW vs. i
78
17.5 Bottom Line

All previously described analysis
methods can apply to the evaluation of
an after-tax cash flow.
Unlike previous chapters where the
cash flow was provided, one must first
construct the ATCF from a problem
specification, then apply the analysis
approaches.
79

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CHAPTER 17
17.6
SPREADSHEET APPLICATIONS
AFTER-TAX INCREMENTAL ROR
ANALYSIS
80
17.6 Example 17.10

Two ATCF alternatives;
Incremental ROR method is presented;

A plot of the two methods for discount
rates varying from 5% to 9% is also
shown;
81
17.6 Example 17.10

A breakeven interest rate equal to
6.35% is determined;
The two alternatives are identical at
6.35% after-tax MARR.
See Section 8.6 of the text!
82
17.6 Figure 17.6
83
17.6 Breakeven Point for Ex. 17.10
The interest rate at

which the two
alternatives are
economically
equal (6.36%)
84
17.6 Example 17.11: Disposal Concerns
85
17.6 Using ROR for ATCF Analysis

Always beware of using the ROR
method for selecting from among
alternatives.
DO NOT use computed ROR!
This means the ROR computed on each

separate investment alternative.
Rather, form the incremental cash flow and
make a determination on the i* value.
Need to design a spreadsheet model to

effectively evaluate.
86

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CHAPTER 17
17.7
AFTER-TAX REPLACEMENT
STUDY
87
17.7 Replacement: After-Tax

Review Chapter 11:
This chapter did not consider taxes in the

analysis.
To properly evaluate a replacementtype 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.
88
17.7 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.
89
17.7 Building a Model for Replacement

Elements than 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.
90
17.7 ATCF Analysis: Example 17.12

Defender:
Purchased 3 years ago for $600,000.

Now outdated due to advancing technology.
Assume classical straight line has been
applied. (In reality, MACRS would be
applied.)
Assume a 8-year recovery life.
Annual Operating Costs: $100,000/year
Worth $400,000 now!
91
17.7 Challenger Asset

First Cost: $1,000,000
Assume straight-line depreciation with a 5year life if purchased.

Annual Operating costs: $15,000/year.
Assume a 0 salvage value at the end of 5
years.
Other Parameters:
BT discount rate: 10%

AT discount rate: 7%
Effective tax rate: 34%
92
17.7 Economic Service Life Analysis

Assume further that a ESL analysis has
been conducted and the following
information is available:
For the Defender: ESL from now is 5 more

years.
For the Challenger: ESL is 5 years.
Assume a 0 salvage value for both
alternatives applies.
93
17.7 BTCF Defender if Retained 5 years
Def.
Age
3
4
5
6
7
8
Life
Discount Rate
(Signed)
Time
Gross
Period
Income
0
1
2
3
4
5
$0
5
10.00%
(+)
Operating
Expenses
$100,000
$100,000
$100,000
$100,000
$100,000
$500,000
(+) or (-)
Investment
or Salvage
-$400,000
$0
-$400,000
NPV Amt
IROR
A. Worth
Calculated
CFBT
-$400,000
-$100,000
-$100,000
-$100,000
-$100,000
-$100,000
-$900,000
-779,079
#NUM!
-205,519
Before-Tax Cash Flow Analysis for Defender

A. Cost to Retain: $205,519/year for 5 years at 10%.
94
17.7 ATCF: Defender Asset

First 5 columns of the ATCF Worksheet:
Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$0
2
$0
3
$0
4
$0
5
$0
$0

(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$400,000
$100,000
$0
$100,000
$0
$100,000
$0
$100,000
$0
$100,000
$0
$500,000
-$400,000
7.00%
(4)
Non-CF
Depreciation
Amt (+) values
$75,000
$75,000
$75,000
$75,000
$75,000
$375,000
(5)
Intermed. Cal.
Taxable
Income (TI)
-$175,000
-$175,000
-$175,000
-$175,000
-$175,000
95
17.7 Last Columns: ATCF Retain Defender

(6)
(-) C.F
Taxes
(7)
Calculated CF
CFAT
-$59,500
-$59,500
-$59,500
-$59,500
-$59,500
-$297,500
NPV
IROR
Ann Worth
-$400,000
-$40,500
-$40,500
-$40,500
-$40,500
-$40,500
-$602,500
-$566,058.00
#NUM!
-$138,056
t
0
1
2
3
4
5
Ann. cost to
retain the
defender
after-tax
analysis.
96
17.7 Challenger: After-Tax

First five columns of the ATCF worksheet for challenger
Tax Rate:
(1)
CF(Signed)
Time
Gross
Period
Income
0
$0
1
$0
2
$0
3
$0
4
$0
5
$0
$0

(2)
(3)
CF(+)
CF(+) or (-)
Operating
Investment
Expenses
or Salvage
$0
-$1,000,000
$15,000
$0
$15,000
$0
$15,000
$0
$15,000
$0
$15,000
$0
$75,000
-$1,000,000
7.00%
(4)
Non-CF
Depreciation
Amt (+) values
$200,000
$200,000
$200,000
$200,000
$200,000
$1,000,000
(5)
Intermed. Cal.
Taxable
Income (TI)
$25,000
-$215,000
-$215,000
-$215,000
-$215,000
-$215,000
Depr. recapture on defender trade-in

97
17.7 Defender Recaptured Depreciation

Defenders book value at the end of
year 3:
$600,000 3 ($75,000) = $375,000.
Assume Defender is sold for $400,000.
SP > BV at time of sale;

Compute: (SP BV);
(400,000 375,000) = +25,000.
Treated as Ordinary Income
Tax: ($25,000)(0.34) = $8,500.
98
17.7 Tax on Recaptured Depreciation

If the defender were retained, then no
tax liability (no recaptured
depreciation).
If the decision to replace is made,
ordinary income amount of $25,000
(gain on sale) is assigned to the
challenger!
Because going with the challenger
would trigger the recaptured
depreciation amount.
99
17.7 Challenger ATCF if Purchased

(6)
(-) C.F
Taxes
(7)
Calculated CF
CFAT
$8,500
-$73,100
-$73,100
-$73,100
-$73,100
-$73,100
-$365,500
NPV
IROR
Ann Worth
-$1,008,500
$58,100
$58,100
$58,100
$58,100
$58,100
-$718,000
-$770,278.53
#NUM!
-$187,864
t
0
1
2
3
4
5
Annual cost if
the challenger
is purchased
is $187,864/yr.
100
17.7 Example Summary

If the defender is retained:
BTCF annual cost:
$205,520/year
ATCF annual cost:
$138,056/year
If the challenger is purchased:

BTCF annual cost:
$278,800/year
ATCF annual cost:
$187,864/year
Retain defender for 5 more years. Reevaluate in one

year if the estimates change.
101
17.7 Technical Note

The last example specified straight-line
recovery;
Typically, MACRS would be used;
For the defender, only a year of
recovery would be permitted.
Thus, all ATCF values would be
different than what has been shown.
102

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CHAPTER 17
17.8
AFTER-TAX VALUE-ADDED
ANALYSIS
103
17.8 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.
104
17.8 Value Added: Example

You 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!
105
17.8 Value Added: Example

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.
106
17.8 Value Added

Rule:
The decision concerning an economic
alternative will be the same for a valueadded analysis and a CFAT analysis.
Because the AW of economic valueadded estimates is the same as the AW
and CFAT estimates!
107
17.8 Value Added: Starting Point

To start, apply Eq. 17.3:
NPAT = Taxable Income taxes
NPAT = (TI)(1-T)
Value added or Economic Value Added

( EVA) is:
The amount of NPAT remaining after removing

the cost of invested capital during the time
period in question.
108
17.8 EVA Explained

EVA indicates the projects contribution
to the net profit of the corporation after
taxes have been paid.
The cost of invested capital is normally
the firms after-tax required MARR value.
One multiplies the AT-MARR by the
current level of capital (investment).
Charge interest on the unrecovered
capital investment at the AT-MARR rate.
109
17.8 EVA and Invested Capital

Recall, firms often have two sets of books
relating to depreciation:
One for tax purposes, and

One for internal management use (book
depreciation).
For EVA, book depreciation is more often used.
More closely represents the true rate of
usage of the assets in question.
110
17.8 EVA Example 17.14

Two Alternatives, A and B
A
4-year life
P = -$500,000 with a 0 salvage value
GI E = $170,000/yr
Which alternative
is preferred using EVA?
4-year life
P = $1,200,000 with 0 salvage value
GI E = {$600,000 decreasing by $50,000/yr}
MARR = 12% (A.T), n = 4, Te = 40%
111
17.8 Example 17.14: Spreadsheet Model

n=
MARR =
Tax Rate
4
12.0%
40.0%
112
17.8: Base Calculations: Plans A and B

End of
Period
0
1
2
3
4
Sums
(1)
GI Exp
$170,000
$170,000
$170,000
$170,000
$680,000
(2)
(3)
Investment Depreciation
P
-$500,000
$125,000
$125,000
$125,000
$125,000
-$500,000
$500,000
(4)
Book
Value
$500,000
$375,000
$250,000
$125,000
$0
(5)
Taxable
Income
$45,000
$45,000
$45,000
$45,000
$180,000
(6)
Taxes
Owed
$0
$18,000
$18,000
$18,000
$18,000
$72,000
(7)
Net Profit
After Tax
$0
$27,000
$27,000
$27,000
$27,000
$108,000
(6)
Taxes
Owed
$0
$120,000
$80,000
$40,000
$0
$240,000
(7)
Net Profit
After Tax
$0
$180,000
$120,000
$60,000
$0
$360,000
Plan A
End of
Period
0
1
2
3
4
Sums
(1)
GI Exp
(2)
(3)
(4)
Investment Depreciation
Book
P
Value
-$1,200,000
$1,200,000
$600,000
$300,000
$900,000
$500,000
$300,000
$600,000
$400,000
$300,000
$300,000
$300,000
$300,000
$0
$1,800,000 -$1,200,000 $1,200,000
(5)
Taxable
Income
$300,000
$200,000
$100,000
$0
$600,000
Plan B
113
17.8 EVA Components EVA-CFAT for A

(8)
Cost of
Invest. Capital
$60,000
$45,000
$30,000
$15,000
$150,000
PW of EVA
AW of EVA
(9)
EVA
NPAT-CoIC
$0
-$33,000
-$18,000
-$3,000
$12,000
-$42,000
-$38,323
-$12,617
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$500,000
$152,000
$152,000
$152,000
$152,000
$108,000
-$38,323
8.31%
-$12,617
114
17.8 EVA Components EVA-CFAT for B

(8)
Cost of
Invest. Capital
$144,000
$108,000
$72,000
$36,000
$360,000
PW of EVA
AW of EVA
(9)
EVA
NPAT-CoIC
$0
$36,000
$12,000
-$12,000
-$36,000
$0
$10,289
$3,388
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$1,200,000
$480,000
$420,000
$360,000
$300,000
$360,000
$10,289
12.44%
$3,388
115
17.8: EVA and CFAT for A and B

(9)
EVA
NPAT-CoIC
$0
-$33,000
-$18,000
-$3,000
$12,000
-$42,000
-$38,323
-$12,617
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$500,000
$152,000
$152,000
$152,000
$152,000
$108,000
-$38,323
8.31%
-$12,617
EVA-CFAT: A
(9)
EVA
NPAT-CoIC
$0
$36,000
$12,000
-$12,000
-$36,000
$0
$10,289
$3,388
(10)
t
0
1
2
3
4
PW
RoR
AW
CFAT
-$1,200,000
$480,000
$420,000
$360,000
$300,000
$360,000
$10,289
12.44%
$3,388
EVA-CFAT: B
B is the preferred option!

116
17.8 EVA Comparisons: A vs. B

Summary Values for A
PW of EVA
AW of EVA
-$38,323
-$12,617
PW
RoR
AW
-$38,323
8.31%
-$12,617
Summary Values for B

PW of EVA
AW of EVA
$10,289
$3,388
PW
RoR
AW
$10,289
12.44%
$3,388
117
17.8 What Does EVA Mean?

Note, the AW (12%) of the EVA and the
CFAT is the same.
Although the values that make up the
EVA column and the values that make
up the CFAT are different,
Their annual worth at 12% is

identical.
118
17.8 Meaning of EVA and CFAT

EVA values represent an alternatives
periodic contribution to the value of the
corporation or firm:
The CFAT values represent the actual
cash flows after tax into the
corporation or firm.
Corporate executives generally prefer
to view the EVA values;
Engineers will tend to compute the
CFAT values.
119
17.8 EVA and Capital Recovery

Refer to Section 6.2 of the text.
Equation [6.3].
For the $500,000 investment in A the

capital recovery amount is:
$500,000(A/P,12%,4) = $164,617/year
over 4 years with a 0 salvage value
assumed.
This amount is charged against the cash
inflows for each year for alternative A.
120
17.8 A Second Point to Consider

For both options, a time-depreciable
(t = 0) investment is required.
This investment is recovered over 4
years (written off for tax purposes).
There remains an unrecovered
investment at the beginning of each
year.
The firms owners expect to earn
interest on the unrecovered investment.
121
17.8 Undepreciated (Unrecovered)

Investment
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.
122
17.8 EVA vs. CFAT

AW of EVA and,
AW of CFAT:
Are identical in amount.

Either method can be 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.
123

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CHAPTER 17
Chapter Summary
124
17 Summary Points
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 ROR evaluations of
one or more alternatives are performed on
the CFAT series: using exactly the same
procedures as in previous chapters.
125
17 Summary Points
The-after-tax MARR is used in all PW and AW
computations, and in deciding between two
or more alternatives using incremental ROR
analysis.
Generally the firm will apply two interest
rates:
MARR value for before-tax analysis;

MARR value for after-tax analysis.
126
17 Summary Points
Income tax rates for U.S. corporations and
individual taxpayers are graduated-higher
taxable incomes pay higher income taxes.
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.
127
17 Summary Points
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

depletion amounts must be considered
as part of the analysis.
128
17 Summary Points
Key general cash flow after-tax relations for
each year are:
CFBT = gross income - expenses - initial
investment + salvage value .
CFAT = CFBT - taxes =
CFBT - (taxable income)(Te).
129
17 Summary Points
Taxable Income (TI):
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.
130
17 Summary Points
Economic Value Added is:
EVA = net profit after taxes - cost of invested

capital
= NPAT - (after-tax MARR)(book value) = TItaxes - i(BV)
The equivalent annual worth of CFAT and

EVA estimates are the same numerically due
to the fact that they interpret the annual cost
of the capital investment in different, but
equivalent manners.
131
17 Summary Points
Economic Value Added is:
EVA = net profit after taxes - cost of
invested capital.
EVA =
NPAT - (after-tax MARR)(book value)
NPAT = TI - taxes - i(BV)
EVA analysis is often preferred by corporate
executives as opposed to CFAT.
132
17 Summary Points
my in the TI computations, and not directly in the CFBT and CFAT calculations.
Accordingly, key general cash flow after-tax relations for each year are CFBT =
gross income - expenses - initial investment + salvage value CFAT = CFBT taxes = CFBT - (taxable income)(TQ)
TI = gross income - expenses - depreciation + depreciation recapture an
alternative's estimated contribution to corporate financial worth is the economic
measure, the economic value added (EVA) should be determined. Unlike FAT,
the EVA includes the effect of depreciation.
EVA = net profit after taxes - cost of invested capital

= NPAT - (after-tax MARR)(book value) = TI-taxes - i(BV)
+e equivalent annual worth of CFAT and EVA estimates are the same
numerically due to the fact that they interpret the annual cost of the capital
investment in different, but equivalent manners.
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,
accounted for in an after-tax analysis. The replacement study procedure of
Chapter 11 is applied. The tax analysis may not reverse the decision to replace
or retain the defender, but the effect of taxes will likely reduce (possibly by
significant amount) the economic advantage of one alternative over the other.
133
17 Summary Points
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 aftertax analysis.
134
17 Summary Points
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.
135
17 Summary Points
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 IRS 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.
136

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CHAPTER 17
End of Slide Set
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ENGINEERING ECONOMY Fifth Edition

ENGINEERING ECONOMY Fifth Edition

17. Learning Objectives

Terminology and Rates

Before- and After-Tax Analysis

Taxes and Depreciation

Depreciation Recapture and Capital Gains

ENGINEERING ECONOMY Fifth Edition

17.1 Important Terms: Gross Income

Total income for the tax year from all

17.1 Income Tax

Federal Corporate Taxes are normally paid

17.1 Operating Expenses (E)

Real Cash Flows,

17.1 Taxable Income (TI)

TI = Gross Income expenses

17.1 Tax Rate T

Taxes = (taxable income) x (applicable rate)

17.1 Net Profit After Tax (NPAT)

Saved by the firm,

17.1 Federal Corporate Tax Rates

No one single rate;

See Table 17-1 for the 8 bracket rates.

17.1 The Eight Federal Tax Brackets (2002)

17.1 Bracket Tax Rates

1st $50,000 (0.15) = $7,500

Now we are in the 4th bracket

Last $100,000 (0.34) = $34,000.

17.1 Total Tax on TI = $200,000

17.1 Marginal Tax Rates

17.1 Tax Bracket Description

Debate this point in class!

For engineering economy studies:

The analyst will not know the exact TI for

17.1 State and Federal

Federal corporate taxes, and possibly

If this is the case, apply a combined tax

17.1 Combined Tax Rate

Effective Tax rate Te as:

Te = state rate + (1 state rate) (Federal

State income taxes are deductible

17.1 Personal vs. Corporate

17.1 Personal vs. Corporate

Corporations have no such filing status

17.1 Individual Tax Rates

See Example 17.2

The bracket amounts depend upon

ENGINEERING ECONOMY Fifth Edition

17.2 NET CASH FLOW NCF

Cash Inflow Cash Outflows for a given

From economy studies the engineer will

17.2 Cash Flows Before Tax (CFBT)

Actual real cash flows associated with an

Next, CFBT will be defined.

17.2 CFBT Defined

17.2 Cash Flow After Tax ( CFAT)

CFAT = CFBT Taxes.

17.2 Expanding the CFAT Amount

17.2 Some Observations

17.2 CFBT: Format

A tabular approach is suggested.

Numerous formats exist and no