Chapter 10

Income tax in economic analysis
 Income tax is the amount of the payment (taxes) on income or profit

that must be delivered to a federal (or lower-level) government unit.
Taxes are real cash flows , for corporations tax computation requires
some noncash elements, such as depreciation.
 Gross income or Operating revenue(GI) is the total income realized

from all revenue-producing sources of the corporation, plus any
income from other sources such as sale of assets, royalties, and license
fees. The incomes are listed in the revenue section of an income
statement
 Operating expenses OE include all costs incurred in the transaction

of business. These expenses are tax-deductible for corporations.
For after-tax economic evaluations, the AOC (annual operating costs)

and M&O (maintenance and operating) costs are applicable.
Depreciation is not included here since it is not an operating expense
 Net operating income NOI, often called EBIT (earnings before interest and
income taxes), is the difference between gross income and operating expenses.
 The basis for income tax computations involves from actual cash flows:
Net operating income = revenue - operating expenses
 The second involves actual cash flows and noncash deductibles, such as
depreciation.
 Taxable income TI is the amount of income upon which taxes are based. A
corporation is allowed to remove depreciation , depletion and amortization, and
some other deductibles from net operating income in determining the taxable
income for a year. For our evaluations, we define taxable income as
Taxable income =revenue(GI) - operating expenses - depreciation

Tax rate (TR) is a percentage, or decimal equivalent of TI that is
owed in taxes. The tax rates in many countries are graduated (or
progressive) by level of TI; that is, higher rates apply as the TI
increases.
The average tax rate paid is calculated separately from the highest
marginal rate used. The general tax computation relation is
Net operating profit after taxes (NOPAT) is the amount remaining

each year after taxes are subtracted from taxable income.
The effective tax rate and taxes are calculated as
U.S. Corporate Federal Income Tax Rate Schedule

BEFORE-TAX AND AFTER-TAX CASH FLOW
 The term net cashflow (NCF) was identified as the best estimate of
actual cash flow each year.
 The NCF is calculated as cash inflows minus cash outflows.
 The annual NCF amounts have been used many times to perform
alternative evaluations via the PW, AW, ROR, and B/C methods.
 Now that the impact on cash flow of depreciation and related taxes
will be considered.
 NCF is replaced by the term cash flow before taxes (CFBT), and we
introduce the new term cashflow after taxes (CFAT).
 CFBT and CFAT are actual cash flows; that is, they represent the
estimated actual flow of money in and out of the corporation that will
result from the alternative.
where taxes are estimated using the relation (TI)(T) or (TI)(Te), as
discussed earlier.
Table Column Headings for Calculation of (a) CFBT and (b) CFAT
1. A tool costing $300 has no salvage value and will be depreciated
over 3 years according to the sum-of-the-years-digits method. The
cash flows before tax due to the tool are shown below. The tax rate is
35%.
2.A state tax of 10% is deductible from the income taxed by the federal
government. The federal tax is 34%. The combined effective tax rate is
3.A company, whose earnings put them in the 35% marginal tax bracket,
is considering the purchase of a new piece of equipment for $25,000.
The equipment will be depreciated using the straight line method over a
4-year depreciable life to a salvage value of $5,000. It is estimated that
the equipment will increase the company’s earnings by $8,000 for each
of the 4 years it is used. Should the equipment be purchased? Use an
interest rate of 10%.
4.A large company must build a bridge to have access to land for
expansion of its manufacturing plant. The bridge could be fabricated of
normal steel for an initial cost of $30,000 and should last 15 years.
Maintenance will cost $1,000/year. If more corrosion resistant steel were
used, the annual maintenance cost would be only $100/year, although
the life would be the same. In 15 years there will be no salvage value for
either bridge. The company pays a combined state and federal income
tax rate of 48% and uses straight-line depreciation. If the minimum
attractive aftertax rate of return is 12%, what is the maximum amount
that should be spent on the corrosion resistant bridge?
5.A one-year savings certificate that pays 15% is purchased for
$10,000. If the purchaser pays taxes at the 27% incremental income tax
rate, what is the rate of return of the investment after tax?
6. If the security division of OnStar has an annual gross income of

$2,750,000 with expenses and depreciation totaling $1,950,000, (a)
compute the company's exact federal income taxes. (b) Estimate total
federal and state taxes if a state tax rate is 8% and a 34% federal
average tax rate applies.
Exercise? .XYZ sells outdoor equipment and sporting goods through
retail outlets, the Internet, and catalogs. Assume that for 1 year has the
following financial results in the state of ABC, which has a flat tax
rate of 6% on corporate taxable income. Total revenue birr 19.9 million
Operating expenses birr 8.6 million Depreciation and other allowed
deductions birr 1.8 million
(a) Determine the state taxes and federal taxes due rates.
(b) Find the average federal tax rate paid for the year.
(c) Determine a single-value tax rate useful in economic evaluations
using the average federal tax rate determined in part (b).
(d) Estimate federal and state taxes using the single-value rate, and
compare their total with the total in part (a).
2.Gillespie Gold Products Inc. is considering the purchase of new
smelting equipment. The new equipment is expected to increase
production and decrease costs with a resulting increase in profits. The
equipment under consideration is summarized below. Determine the
after-tax cash flow using a tax rate of 42% and sum-of-the-years-digits
depreciation.
Cost =$50,000
Net Savings/year= 15,000 the first year decreasing by $1,000 each
year thereafter
Depreciable Life =4 yrs
Actual Useful Life= 6 yrs
Salvage Value =4,000
3.For engineering economic analysis a corporation uses an incremental
state income tax rate of 7.4% and an incremental federal rate of 34%.
Calculate the effective tax rate.
4,A corporation expects to receive $32,000 each year for 15 years if a

particular project is undertaken. There will be an initial investment of
$150,000. The expenses associated with the project are expected to be
$7,530 per year. Assume straight-line depreciation, a 15-year useful life
and no salvage value. Use a combined state and federal 48% income tax
rate and determine the project’s after-tax rate of return.
5.A piece of equipment costing birr 10,000 is expected to produce a
uniform annual net benefit before tax of birr 3,000 in terms of the
base-year dollars over the next 5 years. The equipment has no salvage
value at the end of 5 years and the depreciation allowance is based on
the straight-line depreciation method. The federal and state income
tax rate is 38%, and the after-tax MARR specified by the firm is 8%
excluding inflation. Considering each of the following two cases,
determine whether the investment is worthwhile.
(a) There will be no inflation during the next 5 years.
(b) There will be an annual inflation rate of 5%.

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Income tax in economic analysis

 Income tax is the amount of the payment (taxes) on income or profit

 Gross income or Operating revenue(GI) is the total income realized

 Operating expenses OE include all costs incurred in the transaction

For after-tax economic evaluations, the AOC (annual operating costs)

Taxable income =revenue(GI) - operating expenses - depreciation

Net operating profit after taxes (NOPAT) is the amount remaining

U.S. Corporate Federal Income Tax Rate Schedule

 The NCF is calculated as cash inflows minus cash outflows.

6. If the security division of OnStar has an annual gross income of

4,A corporation expects to receive $32,000 each year for 15 years if a

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