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ENGINEERING ECONOMY Fifth Edition


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Hill

CHAPTER 17

AFTER-TAX ECONOMIC
ANALYSIS

Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

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ENGINEERING ECONOMY Fifth Edition


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Mc

Graw
Hill

CHAPTER 17

Learning Objectives

Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

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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

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ENGINEERING ECONOMY Fifth Edition


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CHAPTER 17
17.1
INCOME TAX TERMINOLOGY AND
RELATIONS FOR CORPORATIONS
AND INDIVIDUALS

Blank & Tarquin: 5th edition. Ch.17 Authored by Dr. Don Smith, Texas A&M University

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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

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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.

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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.

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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]

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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]

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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]

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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.

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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.

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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!

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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!

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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!

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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%

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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%

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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.
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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%.

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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).

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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

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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.

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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.
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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.

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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).
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ENGINEERING ECONOMY Fifth Edition


Blank and Tarquin

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Graw
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CHAPTER 17
17.2
BEFORE-TAX AND AFTER-TAX CASH
FLOW

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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).

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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.

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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.

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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.

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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.
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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!

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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.

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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%

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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..


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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..


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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?

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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.

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ENGINEERING ECONOMY Fifth Edition


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CHAPTER 17
17.3
EFFECT ON TAXES OF DIFFERENT
DEPRECIATION METHODS AND
RECOVERY PERIODS

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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.
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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

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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!

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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!

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17.3 Comparing Depreciation Plans

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CHAPTER 17
17.4
DEPRECIATION RECAPTURE AND
CAPITAL GAINS AND LOSSES FOR
CORPORATIONS

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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.

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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

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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!

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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.

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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.

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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.

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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
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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)

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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

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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.
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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!
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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.

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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

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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

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17.4 Disposal: 4th Situation: SP > B


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.

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17.4 Disposal: 4th Situation: SP > B


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%.
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17.4 Disposal: 4th Situation: SP > B


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

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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)

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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%

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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.

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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!

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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.

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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.

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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.

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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.

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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!

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17.4 Summary for Disposal Analysis

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ENGINEERING ECONOMY Fifth Edition


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Graw
Hill

CHAPTER 17
17.5
AFTER-TAX PRESENT WORTH,
ANNUAL WORTH, AND ROR
EVALUATION

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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, . . .

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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.

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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.

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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)

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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
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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.

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ENGINEERING ECONOMY Fifth Edition


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Graw
Hill

CHAPTER 17
17.6
SPREADSHEET APPLICATIONS
AFTER-TAX INCREMENTAL ROR
ANALYSIS

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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;

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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!

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17.6 Figure 17.6

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17.6 Breakeven Point for Ex. 17.10

The interest rate at


which the two
alternatives are
economically
equal (6.36%)

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17.6 Example 17.11: Disposal Concerns

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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.
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ENGINEERING ECONOMY Fifth Edition


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Graw
Hill

CHAPTER 17

17.7
AFTER-TAX REPLACEMENT
STUDY

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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.

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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.

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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.

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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!

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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%

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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.

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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%.
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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

34.00% Discount Rate Atax


(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

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(5)
Intermed. Cal.
Taxable
Income (TI)
-$175,000
-$175,000
-$175,000
-$175,000
-$175,000

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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.

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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

34.00% Discount Rate Atax


(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


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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.

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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.
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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.

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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.
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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.

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ENGINEERING ECONOMY Fifth Edition


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Graw
Hill

CHAPTER 17

17.8
AFTER-TAX VALUE-ADDED
ANALYSIS

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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.

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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!
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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.

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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!

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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.

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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.

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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.

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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%

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17.8 Example 17.14: Spreadsheet Model


n=
MARR =
Tax Rate

4
12.0%
40.0%

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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
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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

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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

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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!


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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

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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.

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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.
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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.

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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.
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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.

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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.

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ENGINEERING ECONOMY Fifth Edition


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CHAPTER 17

Chapter Summary

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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.

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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.

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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.

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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.

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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).

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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.
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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.
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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.

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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.

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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.

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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.

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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.

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ENGINEERING ECONOMY Fifth Edition


Blank and Tarquin

Mc

Graw
Hill

CHAPTER 17

End of Slide Set

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