The tax code is very complicated for individuals and corporation in the. You probably, at some point in your life, have filled a tax return with the Internal Revenue Service (IRS). Organizations have an even more daunting task with more complicated rules.
16.3.2 After Tax Analysis and Cash Flow
The taxes paid and tax related items like depreciation and investment tax credits have a significant impact on the economics of all aspects of corporate activity, but particularly on Capital Investment.
Economic decision making is based on Cash Flows (not accounting profit). If you take a course in Corporate/Managerial Finance you will find that corporations are managed on the Cash Flow.
Please refer to Lang/Merino Chapter 16 text and slides for further information.
In (Cash Flow) you saw that Cash Flows can be generated as part of:
� Operating Activities
� Capital/Finance Activities
Operating cash flows can be determined from the Income Statement. Note that an operating cash flow is Net Income after Tax plus depreciation. Remember that depreciation is a non-cash (accrual) expense. Operating cash flows are periodic over a number of years.
Capital Cash Flows can be determined from the Balance Sheet. There are a number of activities that impact the Capital Cash Flows. Change in inventory levels, financing activities and capital expenditure are some of these activities. For engineering economics we are interested in investments for depreciable (plant, equipment, etc) and non-depreciable (land) capital. For capital projects we are also interested in loans (to finance capital) and the after tax sale/disposal of capital at the end of the project.
In the following sections we will provide the calculation and format forNet Cash Flow from Operating Activity
� Net Cash Flow from Capital Activity
As well as the After Tax Cash flows for
� Salvage/Disposal of capital items
16.3.3 Net Cash Flow from Operating Activities
Table 16.1 is the modified () Income Statement format used in Engineering Economics for the selection of Capital Projects.
Operating Income before depreciation
1 - 2
3 - 4
Net Cash Flow from Operating
10 + 11
Table 16.1 Net Cash Flow from Operating Activities
Note that the format is very similar to the Income statement format in Chapter 3. The format in Chapter 3 was expanded to include separate items for:
Line: 4:- Depreciation
Line: 6:- Interest Expenses from Loans
Line: 9:- Investment tax credit
Depreciation was added back to the Net Income after Tax to yield the operating cash flow. Note that the $ amounts in this format are for N years where N = Project Life.
16.3.4 Net Cash Flow from Capital Related Line
Table 16.2 is the modified balance sheet format used in Engineering Economics for the selection of Capital Projects.
Net Capital Cash Flow
Table 16.2 Net Cash Flows from Capital Related Activities
You will note that, there are other items that will impact on balance sheet cash flows. For the selection of Capital Projects these include
� Principal Repayment of Loans used to purchase capital goods
� Depreciable and non depreciable capital
� Loans proceeds
� Capital gains/losses when capital is disposed of (salvage)
� Working Capital
You should know the definition of these items and how they differ. Consult Lang/Merino � Chapter 2 and 16 and Chapter 4 � 6 of accounting workbook.
16.3.5 After Tax Cash Flow from Depreciation charges
Note that depreciation is a non-cash (accrual) entry and as such is added back to the Net Income after tax to yield the cash flow from operating activities.
16.3.6 After Tax Cash Flow from Investment Tax Credit (ITC)
From time to time government/agencies (, State and sometimes local)) give incentive for business to make capital Investments. This is usually during a recession or natural disaster (Like Hurricane Katrina) and is designed to increase capital spending.
Why Capital Spending? The concept is that for every dollar spent on capital goods, the Gross National Product (GNP and GDP) will increase many fold (6 to 8 times). In Macro-economics this is called the �Multiplier Effect�.
The ITC allows a company to subtract some part of the Capital purchase price from the Income Tax it pays.
For example, if the ITC is 10% and the company makes a $200,000 capital investment then the company can deduct $20,000 from its taxes (usually in year 0 or 1).
It is assumed that the company will keep the Capital asset in service for a certain number of years. If it does not, it may have to give back some of the ITC. This is called re-capture. You need to seek Tax Counsel on this matter because the rules are complex. ITC for solar panels or energy saving items like Hybrids cars are examples that apply to consumers.
16.3.7 After Tax Cash Flows from Loans
The after tax analysis with loan repayment includes all the steps in Table 16.1 interest expenses. Interest is subtracted from the net cash flow before income taxes are calculated since interest is tax deductible, requiring it to be eliminated from the taxable income.
Interest charges benefit the organization because it reduces the taxable income and, hence, the income taxes. The principal payments can be subtracted in table 16.2 since principal is NOT tax deductible. When dealing with loans, we need to understand the difference between interest and principal. Principal is the actual amount you have borrowed or the remaining, unpaid balance owed to the lender. Interest is most easily described as the fee charged by the lender for lending you the principal. It is usually expressed as an annual percentage of the principal. Interest is generally tax deductible, meaning it REDUCES taxable income.
Table 16.3 provides an example on how to �amortize� a loan. The example assumes that the interest rate is 10% and the loan is repaid in 4 years. The amount of the loan is $80,000. The Annual payment is calculated using the time value of money equation:
A = P (A/P, I, N) = $80,000(A/P, 10, 4)
A = $80,000 x 0.3155
A = $25,240/ year
Beginning-of- year balance
Annual Principal Repayment
10% of (2)
(3) - (4)
(2) � (5)
Student Name: Instructor Class: McGraw-Hill/Irwin Problem 16-04 ZEKANY CORPORATION Calculations 2013 2014 2015 2016 Pretax accounting income $60,000 $80,000 $70,000 $70,000 Depreciation for tax (39,600) (52,800) (18,000) (9,600) Taxable income $20,400 $27,200 $52,000 $60,400 Tax rate 30% 30% 40% 40% Tax payable $6,120 $8,160 $20,800 $24,160 Correct! Correct! Correct! Correct! Cumulative Temporary 2013 2014 2015 2016 Difference Straight-line 30,000 30,000 30,000 30,000 Tax depreciation (39,600) (52,800) (18,000) (9,600) Temporary differences: (9,600) (22,800) 12,000 20,400 $- «- Correct! 2013 (22,800) 12,000 20,400 $9,600 «- Correct! 2014 12,000 20,400 $32,400 «- Correct! 2015 20,400 $20,400 «- Correct! 2016 $- «- Correct! 2013 2014 2015 2016 Cumulative difference $9,600 $32,400 $20,400 $- Tax rate 30% 40% 40% 40% Year-end balance $2,880 $12,960 $8,160 $- Previous balance- (2,880) (12,960) (8,160) Credit/(debit) $2,880 $10,080 $(4,800) $(8,160) Correct! Correct! Correct! Correct! ZEKANY CORPORATION General Journal Account Debit Credit Journal entry at the end of 2013 Income tax expense 9,000 «- Correct! Deferred tax liability 2,880 Income tax payable 6,120 Journal entry at the end of 2014 Income tax expense 18,240 «- Correct! Deferred tax liability