chapter 11 corporate income taxes

(c) 2001 Contemporary Engineering Economics

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Chapter 11Corporate Income Taxes

• Income tax rates

• Average vs. Marginal tax rates

• Gains taxes

• Income tax rate for economic analysis


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Corporate Income Taxes (Year 2000)

Company Gross

Income

Taxable

Income

Income

Taxes

Net

Income

Average

Tax Rate

Intel $33,726 $15,141 $4,606 $10,535 30.42%

Cisco 18,920 4,343 1,675 2,668 38.57%

Amazon 2,762 (1,707) 0 (1,411) 0%

Broadcom 1,132 339 68 271 20.00%

Oracle 17,173 101,232 3,827 6,297 37.80%

(dollars in millions)


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Taxable Income and Income Taxes

Gross IncomeExpenses Cost of goods sold (revenues) Depreciation Operating expensesTaxable incomeIncome taxes

Net income

Item


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Example 11.1- Net Income Calculation

Item Amount

Gross income (revenue) $50,000

Expenses

Cost of goods sold

Depreciation

Operating expenses

20,000

4,000

6,000

Taxable income 20,000

Taxes (40%) 8,000

Net income $12,000


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Capital Expenditure versus Depreciation

Expenses 0

1 2 3 4 5 6 7 8

0 87673 41 2

$4,000

$6,850$4,900

$3,500 $2,500 $2,500 $2,500$1,250

$28,000

Capital expenditure(actual cash flow)

Allowed depreciation expenses (not cash flow)


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Cash Flow vs. Net Income

Net income: Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored.

Cash flow: Given the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, it is desirable why cash flows are relevant data to use in project evaluation.


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Why Do We Use Cash Flow in Project Evaluation?

Company A Company B

Year 1 Net income

Cash flow

$1,000,000

1,000,000

$1,000,000

0

Year 2 Net income

Cash flow

1,000,000

1,000,000

1,000,000

2,000,000

Example: Both companies (A & B) have the same amount ofnet income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 millionat the end of 2nd year. Company A can invest $1 million in year1, while Company B has nothing to invest during the same period.


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Example 11.2 – Cash Flow versus Net Income

Item Income Cash Flow

Gross income (revenue $50,000 $50,000

Expenses

Cost of goods sold

Depreciation

Operating expenses

20,000

4,000

6,000

-20,000

-6,000

Taxable income 20,000

Taxes (40%) 8,000 -8,000

Net income $12,000

Net cash flow $16,000


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Net income versus net cash flow

$0

$50,000

$40,000

$30,000

$20,000

$10,000

$8,000

$6,000

$20,000

Net income

Depreciation

Income taxes

Operating expenses

Cost of goods sold

Netcash flow

Grossrevenue

$4,000

$12,000

Net cash flows = Net income + non-cash expense (depreciation)


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U.S. Corporate Tax Rate (2001)

Taxable income0-$50,000$50,001-$75,000$75,001-$100,000$100,001-$335,000$335,001-$10,000,000$10,000,001-$15,000,000$15,000,001-$18,333,333$18,333,334 and Up

Tax rate15%25%34%39%34%35%38%35%

Tax computation$0 + 0.15($7,500 + 0.25 ($13,750 + 0.34($22,250 + 0.39$113,900 + 0.34$3,400,000 + 0.35$5,150,000 + 0.38$6,416,666 + 0.35

(denotes the taxable income in excess of the lower bound of each tax bracket


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Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000

Taxable income Marginal Tax Rate

Amount of Taxes

Cumulative Taxes

First $50,000 15% $7,500 $7,500

Next $25,000 25% 6,250 13,750

Next $25,000 34% 8,500 22,250

Next $235,000 39% 91,650 113,900

Next $9,665,000 34% 3,286,100 3,400,000

Next $5,000,000 35% 1,750,000 5,150,000

Remaining $1,000,000

38% 380,000 $5,530,000

Average tax rate =$5,530,000

$16, ,.

000 00034 56%


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Example 11.3 - Corporate Income Taxes

Facts:Capital expenditure $100,000(allowed depreciation) $58,000

Gross Sales revenue $1,250,000

Expenses:Cost of goods sold $840,000Depreciation $58,000Leasing warehouse $20,000

Question: Taxable income?


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Taxable income:Gross income $1,250,000- Expenses:

(cost of goods sold) $840,000(depreciation) $58,000(leasing expense) $20,000

Taxable income $332,000

• Income taxes:First $50,000 @ 15% $7,500

$25,000 @ 25% $6,250$25,000 @ 34% $8,500$232,000 @ 39% $90,480

Total taxes $112,730


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• Average tax rate:

Total taxes = $112,730Taxable income = $332,000

• Marginal tax rate:Tax rate that is applied to the last dollar earned

39%

Average tax rate =$112,730

$332,000

33 95%.


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Disposal of Depreciable Asset

• If a MACRS asset is disposed of during the recovery period,

• Personal property: the half-year convention is applied to depreciation amount for the year of disposal. • Real property: the mid-month convention is applied to the month of disposal.


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Disposal of a MACRS Property and Its Effect on Depreciation Allowances


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Depreciation recapture

Gains = Salvage value – book value = (Salvage value - cost basis)

Capital gains

+ (Cost basis – book value)

Ordinary gains

Depreciation recapture is taxed as ordinary income.


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Capital Gains and Ordinary Gains

Cost basis Book value Salvage value

Capital gains

Ordinary gainsor

depreciation recapture

Total gains


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Gains or Losses on Depreciable Asset

Example 11.5: A Drill press: $230,000Project year: 3 yearsMACRS: 7-year property classSalvage value: $150,000 at the end of Year 3

14.29 24.49 17.49 12.49 8.92 8.92 8.92

Full Full Half

Total Dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308Book Value = 230,000 -109,308 = $120,693Gains = Salvage Value - Book Value = $150,000 - $120,693

= $29,308Gains Tax (34%) = 0.34 ($29,308) = $9,965Net Proceeds from sale = $150,000 - $9,965 = $140,035


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Calculation of Gains or Losses on MACRS Property


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How to Determine Income Tax Rate to be Used in Economic Analysis?

Regular Business

Project

Revenues

Expenses

$200,000

$130,000

$40,000

$20,000

Taxable Income

Income Taxes

$70,000

$12,500

$20,000

?


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Incremental Income Tax Rate

Before Undertaking

Project

After Undertaking

Project

The Effect

of Project

Gross revenue $200,000 $240,000 $40,000

Expenses 130,000 150,000 20,000

Taxable income $70,000 $90,000 $20,000

Income taxes $12,500 $18,850 $6,350

Average tax rate 17.86% 20.94% 31.75%


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Before After Incremental

Taxable income $70,000 $90,000 $20,000

Income taxes 12,500 18,850 6,350

Average tax rate 17.86% 20.94%

Incremental tax rate 31.75%

$0

$20,000 $40,000 $60,000 $80,000 $100,000

Regular income from operation

$20,000 incrementaltaxable income due toundertaking project

Marginal tax rate15% 25% 34%

$5,000at 25%

$15,000at 34%

0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%


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Summary

• Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project.

• Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole.


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• For corporations, the U.S. tax system has the following characteristics:

1. Tax rates are progressive: The more you

earn, the more you pay.

2. Tax rates increase in stair-step fashion:

four brackets for corporations and two

additional surtax brackets, giving a total

of six brackets.

3. Allowable exemptions and deductions

may reduce the overall tax assessment.


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• Marginal tax rate is the rate applied to the last dollar of income earned;

• Average (effective) tax rate is the ratio of income tax paid to net income; and

• Incremental tax rate is the average rate applied to the incremental income generated by a new investment project.

• Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%.

• Capital losses are deducted from capital gains; net remaining losses may be carried backward and forward for consideration in years other than the current tax year.


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• An investment tax credit is a direct reduction of income taxes payable, arising from the acquisition of depreciable assets. Government uses the investment tax credit to stimulate investments in specific assets or in specific industries.

chapter 11 corporate income taxes

Documents

net cash flows

net incomenet income

ofnet income

cash sum

net incomecash flow

actual timing of cash

corporate tax rate

tax computation