IEM 5503 - Financial and Advanced Capital Investment Analysis Canada Chapter 7 Consideration of Depreciation and Income Taxes!

Dr. Ricki G. Ingalls" Fall 2012

2010 Ricki G. Ingalls. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced or used in any form or by any meansgraphic, electronic, or mechanical, including photocopying, recording, 1 taping, Web distribution or information storage and retrieval systemswithout the written permission of the author."

Depreciation"
Property is depreciable if it meets these condi5ons:
It must be used in business or held for the produc5on of income It must have a determinable life and the life must be longer than one year It must be something that wears out, decays, and gets used up, becomes obsolete, or loses value from natural causes.
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Depreciation"
Depreciable property is may be classied as tangible or intangible.
Tangible: can be seen or touched Intangible: property such as a copyright or a franchise

In addi5on, it can be classied as real or personal.

Real: land and anything that is erected on, growing on, or aAached to the land. Land, itself, is not depreciable. Personal: can be transported, such as machinery or equipment.
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Depreciation Methods"
Straight-Line Deprecia5on Declining Balance Deprecia5on Units of Produc5on Deprecia5on

Straight-Line Depreciation"
Constant amount is depreciated each year over the life of the asset. Variables:
N: depreciable life of the asset in years. B: cost basis dk: annual deprecia5on deduc5on in year k BVk: book value at end of year k BVN: es5mated book value in year N dk*: cumula5ve deprecia5on through year k

Formulas

dk = (B BVN)/N dk* = kdk BVk = B dk*

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Example 7-1"
A machine costs $15,000 installed. The allowable write-o period is 12 years, at which 5me the salvage value is $1500. What is the annual deprecia5on charge and the book value at the end of year 3? Solu5on
d = (B-BVN)/N = (15000 1500)/12 = 1125. BV3 = B 3d = 15000 3(1125) = 11625
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Declining Balance Method"

It is some5mes called the constant percentage method. It assumes that the deprecia5on in a given year is a certain percentage (R) of the value of the asset in the beginning of that year.
R = 2/N if a 200% declining balance is used R = 1.5/N if a 150% declining balance is used

Declining Balance Method"

The following rela5onships hold for a declining balance method:
d1= BR dk = B(1 R)k-1R dk* = B(1 (1 R)k) BVk = B(1 R)k BVN = B(1 R)N

In order for the book value to equal the es5mated salvage value at the end of N years, R should be calculated as BVN N R =1 B
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Example 7-2"
A machine costs $15,000 installed. The allowable write-o period is 12 years, at which 5me the salvage value is $1500. What is the deprecia5on charge in year 4 and the book value at the end of year 3 using 200% declining balance deprecia5on? Solu5on
R = 2/12 = 0.1667 BV3 = B(1-R)3 = 15000(0.8333)3 = 8679.51 d4 = B(1-R)3R = 15000(0.8333)3(0.1667) = 1446.88
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Example 7-3"
Calculate R for Example 7-2 if there is a salvage value of $1500 at the end of 12 years
R =1 12 1500 =1 0.826 = 0.174 15000

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Units of Production Depreciation"

When the primary loss of value has to do with use rather than ?me, you can use the Units of Produc?on Deprecia?on Method.
Deprecia5on Per Unit = (B BVN)/ Es5mated Units

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Comparison of Methods"
Machine that has $16000 investment, $1000 salvage value and 5-year life.
Excel Example 7-4

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Tax Reform Act of 1986"

Modied Accelerated Cost Recovery System (MACRS) was created by the Tax Reform Act of 1986 (TRA 86). MACRS is mandatory for most tangible depreciable assets placed in service afer July 31, 1986.
Alterna5ve methods are not allowed

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Tax Reform Act of 1986"

MACRS consists of two methods for deprecia5ng property:
General Deprecia5on System (GDS) Alternate Deprecia5on System (ADS)

GDS is normally used MACRS allows a business to recoup the cost basis of recovery property over a recovery period.
Cost basis includes cost of property plus cost of making the asset serviceable including shipping and handling, insurance, installa5on and training.
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Procedure for Computing MACRS Depreciation Deductions"

Determine the propertys pre-1981 Asset Deprecia5on Range (ADR) guideline period (Table 7-2) Ascertain MACRS property class for recovery period (Table 7-3) Determine MACRS Rates (Table 7-4) Compute deprecia5on deduc5on in year k by mul5plying the cost basis by the appropriate rate from Table 7-4.
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MACRS Rules"
The property is assume to have a salvage value of 0 at the end of the life. The IRS assumes that the property is purchased at the half-way point through the year, so
When you nally determine the actual number of years to depreciate (N), then you will have year deprecia5on in year 1 and year N+1. A property whose N = 3 will have deprecia5on in 4 years.
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Table 7-2"

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Table 7-3"

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Table 7-4"

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The Alternate MACRS Method"

Elec5on to adopt the ADS for a class of property applied to all property in that class placed in service during the tax year. The decision to use the ADS is irrevocable for the assets where it has been applied. Deprecia5on is calculated using (1) the straight- line deprecia5on with BVN+1=0 and (2) a half-year conven5on for the depreciable life of the property.
Use the number of years in Table 7-2, not 7-3
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Income Taxes"

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Introduction to Income Taxes"

Property Taxes are based on the valua5on of the property owned. Sales Taxes are taxes imposed on product sales, usually at the retail level. They are relevant only to the extent that they raise the cost of a purchased item. Excise Taxes are taxes imposed upon the manufacture of certain products such as alcohol and tobacco. Income Taxes are taxes on pretax income. Income taxes are also levied on gains on the disposal of capital property.
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When Income Taxes Should Be Considered"

Whenever possible. You should have to jus5fy whenever you do not use income taxes as part of the analysis. The primary dierence: Afer tax cash ows must be used instead of before tax cash ows

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Effective Tax Rate"

The eec?ve tax rate is the actual rate of taxes levied on a corpora5on from all sources federal, state and local. Eec5ve Tax Rate can be calculated, but may include not only income taxes, but tax rebates, holidays, incen5ves, etc. A simple view of ETR only considers Federal and State Taxes
EFT = Federal + State (Federal)(State)

For Federal Tax Rate of 35%, State of 8%

EFT = 0.35 + 0.08 (0.35)(0.08) = .402 or 40.2%

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Losing Money"
Income Taxes are not paid when the company loses money.
If a project were to lose money, but it is believed the company is otherwise protable, the reduc5on income taxes can be considered. If you are analyzing the en5re company, if the company loses money, then zero taxes are paid. You cannot claim the income tax savings.
For example, for a 35% tax rate, if the project loses $1000, then you can also claim an income tax savings of $350.

A company can used Loss Carryforward, which is explained on the next slide.
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Loss Carryforward"
What Does Loss Carryforward Mean?
An accoun5ng technique that applies the current year's net opera5ng losses to future years' prots in order to reduce tax liability. Generally accepted accoun5ng principles (GAAP) specify that loss carryforwards can be used in any one of the seven years following the loss. For example, if a company experienced a nega5ve net opera5ng income (NOI) in year one but posi5ve NOI in one of the next two to seven years, the company could reduce its tax expense for one of those years by applying the loss experienced in the rst year.

Investopedia explains Loss Carryforward

Most project analysis can take into account income tax implica5ons but not Loss Carryforward implica5ons.

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Income Taxes on Capital Gains (and Losses)"

When an asset is disposed of, the gain (or loss) is taxed at the corporate income tax level. Capital Gain (or Loss) = Net Selling Price Book Value OR Capital Gain (or Loss) = Net Selling Price Cost Basis + Accumulated Deprecia5on Deduc5ons
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Investment Tax Credit"

An Investment Tax Credit allows a tax credit on a percentage of a qualied capital investment. If a company buys a piece of equipment for $250,000 and there is a 10% ITC, then the company lowers it tax burden by 10% of $250,000 or $25,000. ITC does not aect the Basis Value of the asset or the deprecia5on schedule of the asset. Many states have ITC.
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Investment Tax Credit"

Currently, there is no Investment Tax Credit at the Federal level that would eect a typical project. Current Federal Tax Credits Include: (hAp://www.irs.gov/ publica5ons/p542/ar02.html#d0e2085)

A corpora5on's tax liability is reduced by allowable credits. The following list includes some credits available to corpora5ons. Credit for federal tax on fuels used for certain nontaxable purposes (see Publica5on 378, Fuel Tax Credits and Refunds). Credit for prior year minimum tax (see Form 8827). Foreign tax credit (see Form 1118). General business credit Nonconven5onal source fuel credit (see Form 8907). Possessions corpora5on tax credit (see Form 5735). Qualied electric vehicle credit (see Form 8834). Qualied zone academy bond credit (see Form 8860). Clean renewable bond credit (see Form 8912). Gulf bond credit (see Form 8912).

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From Before Tax Cash Flow to After Tax Cash Flow"

Variable Deni5ons
Rk: revenues (or posi5ve cash ow) from the project in year k. Ek: cash ouulows in year k. dk: sum of all noncash, or book, costs during year k, including deprecia5on and deple5on t: eec5ve income tax rate on ordinary income Tk: income taxes paid during year k ATCFk: Afer Tax Cash Flow for the project in year k
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From Before Tax Cash Flow to After Tax Cash Flow"

Year Before Tax Cash Flow Deprecia5on Taxable Income Cash Flow for Income Taxes A;er-Tax Cash Flow k (A) Rk Ek (B) dk (C) = (A) (B) Rk Ek - dk (D) = -t(C) -t(Rk Ek dk) (E) = (A) + (D) (1 t)(Rk Ek) + tdk

Assumes that loses can result in a posi5ve cash ow from a reduc5on in income taxes. If this assump5on is not valid, then:

Cash Flow for Income (D) = MIN(0,-t(C)) MIN(0,-t(Rk Ek dk)) Taxes A;er-Tax Cash Flow (E) = (A) + (D) (Rk Ek) + MIN(0,- t(Rk Ek dk))
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What Is A Tax Holiday?"

A Tax Holiday is a tax deferral that one country gives to a company for doing business in that country. Subsidiaries of interna5onal companies doing business in that country benet from the tax holiday.

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Corporations and Subsidiaries"

Most large corpora5ons are mul5-na5onal corpora5ons
The parent company is incorporated in the home country of the company Wholly-owned subsidiaries are formed in any other country where the company does business. For example: A US Company that does business in the UK will have a UK subsidiary that is wholly- owned by the parent US company
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Taxes In Each Country"

If the parent company is based in the US, its US corporate taxes are based on the prots of the US company. A subsidiary can claim prot of its own

If it is a manufactured product, the prot margin is determined by the normal market prot margin for that type of product in the market. It is also generally agreed to by both the parent companys country and the subsidiary's country.

Either directly, but selling product in the subsidiarys country for a prot Or by manufacturing product that is then transferred to the parent company or one of its subsidiaries for a prot

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How The Accounting Works"

$120 $100 $80 $60 $40 $20 $0 Product Prot Product Value

Subsidiary (S) buys material and supplies labor and overhead for an investment of $100. This is real money. The normal prot margin is 10%, so S can claim $10 prot. S transfers the product to the Parent (P) for $110. P claims an expense of $110 on their taxes
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How The Prot Is Taxed"

$120 $100 $80 $60 $40 $20 $0 Product Prot Product Value

S pays no taxes on the $10 prot in S country because of the tax holiday. P claims the $10 prot of S as an expense on its taxes. If the tax rate in P country is 35%, then P saves $3.50 on its income taxes. Cash paid by the company is $100 - $3.50 = $96.50.
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Does This Always Work?"

Yes it is interna5onal law and it works this way as long as the parent country has a higher tax rate than the subsidiary country. The key is not to repatriate the prot to the parent companys country. If the prot is ever brought into the parent companys country, then it is considered revenue and it is taxed.

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What If Its The Other Way"

If the parent country is a lower tax country than the subsidiary country, then the prots will be repatriated to the parent companys country to lower the overall tax burden.

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Conclusions on Income Taxes"

Income Taxes can be very complicated, especially considering all of the tax credits, surcharges, etc. at every level of government. Your company will be able to give you the companys eec5ve tax rate for analysis purposes. You should take into account special tax breaks for your par5cular project, such as Investment Tax Credits, as a benet for your project.
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