Bantegui, Maria Alexandra Kristine M.

CE40 – E01
CESE – 5 Assignment 5 – Income Taxes and Replacement Analysis

1. Income Taxes

Corporate income tax is an extremely complex subject. Income taxes are beyond the control of a
company insofar as negotiation and litigation with the Internal Revenue Service and state tax
departments are concerned. Income taxes, however, are important because of their affect on a firm's
cash flow.

The subject of engineering economic analysis would not be complete without the inclusion of a
discussion on the effects of federal and state taxes on the time value of money, rates of return, and
economic decisions. Decisions made by engineers and managers are affected by tax implications;
therefore, taxes are factored into engineering economic analysis problems to determine the after-tax
rate of return on the investments entered into by corporate entities and individuals.

1.1. Capital Gains and Losses

A capital gains tax is levied on the profit from the sale of assets like buildings, equipment, and
land. The amount of time an asset has been held as a long-term capital gain (or loss) must be
more than 1 year under current law. For an asset to qualify it must meet two requirements—the
nature of the asset and the time held—to qualify for a reduced tax. Short-term capital gain (or
loss) occurs if the time held is less than for a long-term capital gain.

The net capital gain (or loss) is the sum of the long-term and short-term capital gains and is
generally taxed for corporations at the same rate as ordinary income in the year the gain occurs.
In most economic evaluations, capital gains (or losses) are not considered. The formula for
calculating the capital gain is:

Capital gain = Selling price — Adjusted basis of purchase price (original price + cost of all
renovations)
A company could also have a capital loss if an asset or real property is sold for an amount lower
than the book value at the time of the sale. Equation 14.3 is the formula for calculating a capital
loss:
Capital loss Book value (cost — depreciation to date) — Selling price
Capital losses could be carried forward for three years or carried backward for five years using
amended tax returns for previous years. Capital losses are carried forward or backward when
there is insufficient income to deduct the loss against in the year the loss is incurred by a firm or
an individual taxpayer.
Bantegui, Maria Alexandra Kristine M. CE40 – E01
CESE – 5 Assignment 5 – Income Taxes and Replacement Analysis

1.2. Gross and Taxable Income

The amount of federal corporate income taxes paid by businesses is based on the taxable income
of a business and the corporate tax rate for the appropriate year. The starting point for
determining taxable corporate income is the adjusted gross income, which includes all of the
revenue earned by a firm during the year. These expenditures do not include capital expenditures
because capital expenditures are recovered through depreciation, the second item subtracted
by businesses from adjusted gross income. Below is the formula for calculating the taxable
income of a business:
Taxable business income = Adjusted gross income — All expenditures (except capital
expenditures) — Depreciation
where
Adjusted gross income is all income from revenue generating sources
Expenditures are all costs incurred while transacting business
Depreciation is calculated using one of the four IRS approved methods

Firms could also have an operating loss rather than income and an operating loss is a net loss
rather than a net profit.

1.3. After-Tax Cash Flow

Once firms are able to calculate their taxes, then the taxes are incorporated into engineering
economic analysis evaluations to determine the after-tax cash flow (ATCF). After-tax cash flows
are used when calculating the after-tax rate of return, net present worth, future worth, and
equivalent uniform annual worth. The principal elements of ATCFs are the
following:
1. Before-tax cash flows
2. Depreciation
3. Recaptured depreciation
4. Capital gains
5. Taxable income (adjusted gross income — business expenses — depreciation)
6. After-tax cash flow (before tax cash flow — taxes)
Bantegui, Maria Alexandra Kristine M. CE40 – E01
CESE – 5 Assignment 5 – Income Taxes and Replacement Analysis

2. Replacement Analysis

Replacement projects are decision problems involving the replacement of existing obsolete or worn-
out assets. The continuation of operations is dependent on these assets. Failure to make an
appropriate decision result in a slowdown or shutdown of the operations. The question is, when
should the existing equipment be replaced with more efficient equipment? This situation has given
rise to the use of the terms “defender and challenger”, terms commonly used in the boxing world. In
every boxing class, the current defending champion is constantly aced with a new challenger. In
replacement analysis, the defender is the existing machine (or system), and the challenger is the best
available replacement equipment.

An existing piece of equipment will be removed at some future time, either when the task it performs
is no longer necessary or when the task can be performed more efficiently by newer and better
equipment. The question is not whether the existing piece of equipment will be removed, but when
it will be removed. A variation of this question is, why should we replace existing equipment at this
time rather than postponing replacement of the equipment by repairing or overhauling it? Another
aspect of the defender-challenger comparison concerns deciding exactly which equipment is the best
challenger. If the defender is to be replaced by the challenger, we would generally want to install the
very best of the possible alternatives.

The most common problem encountered in considering the replacement of existing equipment is the
determination of what financial information is actually relevant to the analysis. Often, a tendency to
include irrelevant information in the analysis is apparent.

2.1. Relevant Information for Replacement Analysis

In all replacement analyses, the relevant cost is the current market value of the equipment. The
original cost, repair cost, and trade-in value are irrelevant. A common misconception is that the
trade-in value is always the same as the current market value of the equipment and thus could
be used to assign a suitable current value to the equipment.

In a proper engineering economic analysis, only future costs should be considered; past or sunk
costs should be ignored. Thus, the value of the defender that should be used in a replacement
analysis should be its current market value, not what it cost when it was originally purchased and
not the cost of repairs that have already been made on the machine.
Bantegui, Maria Alexandra Kristine M. CE40 – E01
CESE – 5 Assignment 5 – Income Taxes and Replacement Analysis

The driving force for replacing existing equipment is that equipment becomes more expensive to
operate with time. The total cost of operating a piece of equipment may include repair and
maintenance costs, wages for operators, energy consumption costs, and costs of materials.
Increases in any one or a combination of these cost items over a period of time may lead us to
find a replacement for the existing asset. Since the challenger is usually newer than the defender
and often incorporates design improvements and newer technology, it will likely be cheaper to
operate than the defender.

2.2. Cash Flow Approach

The cash flow approach can be used as long as the analysis period is the same for all replacement
alternatives. In other words, we consider explicitly the actual cash flow consequences for each
replacement alternative and compare them, based on either PW or AE values.

2.3. Opportunity Cost Approach

Instead of deducting the salvage value from the purchase cost of the challenger. we consider the
salvage value as a cash outflow for the defender (or investment required in keeping the
defender).

2.4. Required Assumptions and Decision Frameworks

In deciding whether now is the time to replace the defender, we need to consider the
following three factors:
1. planning horizon (study period).
2. technology, and
3. relevant cash flow information.

By planning horizon. we simply mean the service period required by the defender and a sequence
of future challengers. The infinite planning horizon is used when we are unable to predict when
the activity under consideration will be terminated. In other situations. it may be clear that the
project will have a definite and predictable duration. In these cases. Replacement analysis should
be formulated more realistically based on a finite planning horizon.

Many varieties of predictions can be used to estimate the patterns of revenue, cost. and salvage
value over the life of an asset. Sometimes revenue is constant. but costs increase and salvage
value decreases, over the life of a machine. In other situations, a decline in revenue over
equipment life can be expected. The specific situation will determine whether replacement
Bantegui, Maria Alexandra Kristine M. CE40 – E01
CESE – 5 Assignment 5 – Income Taxes and Replacement Analysis

analysis is directed toward cost minimization (with constant revenue) or profit maximization
(with varying revenue).

Although the economic life of the defender is defined as the number of years of service that
minimizes the annual equivalent cost (or maximizes the annual equivalent revenue), the end of
the economic life is not necessarily the optimal time to replace the defender. The correct
replacement time depends on certain data for the challenger, as well as on certain data for the
defender.

As a decision criterion, the AE method provides a more direct solution when the planning horizon
is infinite. When the planning horizon is finite, the PW method is more convenient to use.