Engineering Economics

Chapter 12
Corporate Income Taxes

1. Taxes
• A tax is a monetary charge imposed on people, organizations, or property for ____________
__________________.

2. Government Partnership
• The U.S. government is essentially a _________________ in every business activity.

• The government shares in the _______________ of every successful venture and the losses
of every ________________ venture.

3. Taxable Income of Business Firms

• The starting point for determining taxable income is _______________________.

• All ordinary and necessary ____________________ (except _________________________)

to conduct the business are deducted from gross income.

• Capital expenditures are allowed on a period-by-period basis in the form of

____________________ and ____________________.

• The treatment of capital expenditures for tax purposes may lead to a taxable income of a firm
that is quite different than the actual ___________________________ of the firm.

• In addition to depreciation and depletion, ____________________________________ is

another type of business tax deduction.

• Taxable Income = Gross Income

– All expenses except capital expenses
– Depreciation and depletion charges
– Other (non-expensed) allowable deductions
4. Income Tax Rates
• Income tax rates in the U.S. are based on an incremental scale.

• The rates applied to different levels of income are called _____________________ or

___________________ tax rates.

• In addition to federal income taxes, most corporations pay state income taxes.

• State taxes are allowed as an itemized deduction (i.e., “write off” ) when calculating federal
taxable income.

• Federal taxes are generally not deductible when calculating state taxable income.

• Combined Incremental ( ∆ ) Tax Rate =

• For economic analysis purposes, we use the incremental tax rate that applies to the change in
projected taxable income.

5. Income Tax Fundamentals

• GI = ________________

• EXP = expenses (except depreciation, depletion, and income taxes)

• BTCF = Before-Tax Cash Flow

= __________________________

• TI = Taxable Income

• Tax = Incremental Tax Rate * Taxable Income

• ATCF = After-Tax Cash Flow

6. Cash Flow Tables
• It is often beneficial to use a cash flow table when calculating after-tax cash flows.

• An example follows. Please note that the number of columns varies based on the type(s)
and number of tax deductions.

34%
EOY NCFBT Dt TI Tax NCFAT
0
1
2
3
n
n (s.v.)

• The last year of the cash flow table is separated into two portions.

• The first portion is devoted to the regular transactions that occur in the year.

• The second portion (i.e., the s.v. row) is devoted to the salvage value of the asset.

• By separating the salvage portion, it is easier to determine whether a _________________

occurs on the salvage of the asset. This is important for ___________________________.
7. Ordinary and Capital Gains
• An ordinary gain (a.k.a., depreciation recapture) occurs when a depreciated asset is sold for
more than the ____________________________________________.

• If more than the cost basis is received, only the amount up to the original cost basis is an
ordinary gain.

• An ordinary gain is taxed as ordinary income.

• A capital gain occurs when an asset is sold for more than the _________________________.

• In most economic analyses, capital gains are uncommon because business and production
equipment and facilities almost always lose value over time.

• Capital are much more likely to occur for non-depreciated assets such as stocks, bonds, real
estate, jewelry, art, and collectibles.

• See current IRS publications for the tax treatment of capital gains for individuals (short-term
gains vs. long-term gains).

• For corporations, capital gains are taxed as ordinary income.

8. Ordinary and Capital Losses

• An ordinary loss occurs when a depreciated asset is sold for less than the book value.

• An ordinary loss reduces the overall taxable income of a profitable business.

• A capital loss occurs when a non-depreciated asset is sold for less than the original cost basis.

• See current IRS publications for the tax treatment of capital losses for individuals and
corporations.

9. After-Tax MARR
• After-tax cash flows provide a more realistic determination of the profitability of a
corporation.

• Because of the impact of taxes, the MARR used for after-tax analysis calculations will be
lower than that used for before-tax analysis calculations.
10. Example
• Will B. Lean, an Industrial Engineer for Golden Rulers, Inc., is responsible for performing an
economic analysis for a piece of equipment that costs $300,000.

• The equipment is estimated to save the company $87,000 per year in labor costs. Operating
and maintenance costs for the equipment are estimated to be $10,000 per year.

• The useful life (to the company) of the equipment is 7 years, after which a $50,000 salvage
value is estimated.

• If purchased, the company will pay $100,000 out of pocket and use a 4-year, 7.5% loan to
pay the remaining balance. The terms of the loan call for equal annual payments.

• Given a MACRS 5-year class life for depreciation, an incremental tax rate of 34%, and an
after-tax MARR of 15%, should Will recommend that the company purchase the equipment?

Depreciation Calculations
Loan Payment =

Loan Table

Year Amount Owed Interest Amount Paid

Beginning of on Principal
Year

4
 EOY BTCF Loan C.F. Interest Depr. T.I. Tax (34%) ATCF
0
1
2
3
4
5
6
7
7 (s.v.)

Given the above ATCF’s, the after-tax ROR = ______________.

Based on the company’s after-tax MARR of 15%, Will _____________________________________.