Chapter 11 - Income Taxes Click here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. RosenkrantzIndustrial & Manufacturing Engineering Department

Cal Poly Pomona

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EGR 403 - The Big Picture• Framework: Accounting & Breakeven Analysis• “Time-value of money” concepts - Ch. 3, 4• Analysis methods

– Ch. 5 - Present Worth– Ch. 6 - Annual Worth– Ch. 7,7A,8 - Rate of Return (incremental analysis)– Ch. 9 - Benefit Cost Ratio & other methods

• Refining the analysis– Ch. 10, 11 - Depreciation & Taxes– Ch. 12 - Replacement Analysis– Sanjeev Ghai Income Tax

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Income Taxes

• Taxes have an impact on cash flow and affect the decisions management makes concerning investments.

• Integrating tax considerations into economic analysis requires a thorough understanding of two issues.– How the taxes are imposed.

– How they affect the economic analysis techniques.

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A Partner(s) in the Business

For simplification the text focuses on either Federal Income taxes or bundles the tax into a rate that reflects all taxing entities. This is done as the taxes at the state or local level vary widely in the manner in which they are administered.

Type of tax-Income tax based on earnings-Property tax based on property value-Sales tax based on purchase price-Use tax based on type of use of an item.

Collected by-Federal-State-County-City

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General Process

• Understand the tax laws affecting the project of interest.

• Estimate the cash flows without considering the effect of taxes.

• Adjust the cash flow based on the effects of depreciation and income taxes.

• Determine the after-tax measure of interest (PW, IRR, payback, etc.).

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Calculation of Taxable Income

• Tax laws can be very complex leading to very complex calculations.

• A tax is just another disbursement for services rendered.

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Classification ofBusiness Expenditures

• Capital expenses.– Expenditures for depreciable assets.

• Generally those items having a life in excess of one year.

– Expenditures for non-depreciable assets.• Generally land, as land has no finite life.

• Operating expenses.– Materials, labor, overhead, rents, leases, equipment

having a life of less than one year.

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Taxable Income of Business Firms

• Taxable income = gross income - operating expenses - depreciation