Depreciation and Income Taxes

Содержание

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Objective The objective is to introduce some of the concepts and

Objective
The objective is to introduce some of the concepts and mechanics

of depreciation and depletion, some historical depreciation methods, as well illustrate different types of taxes
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General Accounting General Accounting: Preparation of financial statements for a firm.

General Accounting

General Accounting:
Preparation of financial statements for a firm. A financial statement (or financial

report) is a formal record of financial activities of a business, person, or other entity
Cost Accounting:
A branch of general accounting that deals with the measurement of costs
Depreciation Accounting:
A branch of general accounting that deals with capital assets depreciation
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General Accounting Balance sheet: Static picture of assets, liabilities and net

General Accounting

Balance sheet:
Static picture of assets, liabilities and net worth at

a single point in time or a summary of financial balances of a corporation
Assets, liabilities and ownership equity (or shareholder’s equity = initial amount of money invested into a business) are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition"
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It is comprised of the following 3 elements: Assets: Something a

It is comprised of the following 3 elements:

Assets: Something a business owns

or controls (e.g. cash, inventory, plant and machinery, etc.)
Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc.)
Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities.
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Balance Sheet Sample

Balance Sheet Sample

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General Accounting Profit and loss statement: Also called “income statement” Income

General Accounting
Profit and loss statement:
Also called “income statement”
Income Statement reports the

company's financial performance in terms of net profit or loss over a specified period.
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Income Statement Income Statement is composed of the following two elements:

Income Statement

Income Statement is composed of the following two elements:
Income: What

the business has earned over a period (e.g. sales revenue, dividend income, etc.)
Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc.)
Net profit or loss is arrived by deducting expenses from income.
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Cost Accounting Costs incurred to produce and sell an item or

Cost Accounting

Costs incurred to produce and sell an item or product

are classified as:
Direct labor
Direct material
Manufacturing cost
Administrative cost
Selling cost
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Direct Costs Direct material: Material whose cost is directly charged to

Direct Costs
Direct material:
Material whose cost is directly charged to a product
Measured

as the sum of charges for materials necessary to produce the product
Direct labor:
Labor cost directly attributable to a product
Measured by multiplying direct labor hours by the hourly wage rate
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Manufacturing Costs Factory Overhead: Indirect labor costs (sick leaves, vacations, bonuses

Manufacturing Costs

Factory Overhead:
Indirect labor costs (sick leaves, vacations, bonuses as well

as labor connected to inspection, cleaning…)
Indirect material costs (costs of materials that cannot be attributed to a particular product)
Fixed costs (taxes, insurance, depreciation, maintenance)
Factory Costs are the sum of:
Direct labor costs
Direct material costs
Factory overhead
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Administrative and Selling Costs Administrative costs: Salaries of executive and clerical

Administrative and Selling Costs

Administrative costs:
Salaries of executive and clerical personnel, office

space, traveling, auditing, necessary to direct the whole enterprise (not just its production or selling activities)
Selling costs
Any expense involved in selling the products or services that tie in directly with sales (selling commissions, market surveys, selling bags, advertising)
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Depreciation As time passes, the assets lose value or depreciate Physical

Depreciation

As time passes, the assets lose value or depreciate
Physical loss
Use

related
Time related
Functional loss
Efficiency (technology) related
Demand (changing tastes) related
Capacity related
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DEPRECIATION Decrease in value of physical properties with passage of time

DEPRECIATION
Decrease in value of physical properties with passage of time and

use
Accounting concept establishing annual deduction against before-tax income
- to reflect effect of time and use on asset’s value in firm’s financial statement
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PROPERTY IS DEPRECIABLE IF IT MUST : be used in business

PROPERTY IS DEPRECIABLE IF IT MUST :

be used in business or

held to produce income
have a determinable useful life which is longer than one year
wear out, decay, get used up, become obsolete, or lose value from natural causes
not be inventory, stock in trade, or investment property
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DEPRECIABLE PROPERTY TANGIBLE - can be seen or touched personal property

DEPRECIABLE PROPERTY

TANGIBLE - can be seen or touched
personal property -

includes assets such as machinery, vehicles, equipment, furniture, etc...
real property - anything erected on, growing on, or attached to land
(Since land does not have a determinable life itself, it is not depreciable)
INTANGIBLE - personal property, such as copyright, patent or franchise (out of scope of the lecture)
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WHEN DEPRECIATION STARTS AND STOPS Depreciation starts when property is placed

WHEN DEPRECIATION STARTS AND STOPS

Depreciation starts when property is placed in

service for use in business or for production of income
Property is considered in service when ready and available for specific use, even if not actually used yet
Depreciation stops when cost of placing it in service has been recovered or it is retired from service
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DEPRECIATION CONCEPTS The following terms are used in the classical (historical)

DEPRECIATION CONCEPTS

The following terms are used in the classical (historical) depreciation

method equations:
N = depreciable life of the asset in years
P = adjusted or cost basis, including allowable adjustments (cost of improvement or theft)
D t = annual depreciation deduction in year t (1< t TD t = cummulative depreciation through year t
BV t = book value at the end of year k
BV N = book value at the end of the depreciable (useful) life
SV N = salvage value at the end of year N
d = the ratio of depreciation in any one year to the BV at the beginning of the year
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Value of an asset Market value The actual value an asset

Value of an asset

Market value
The actual value an asset can be

sold for
Book value
The depreciated value of an asset as shown on the accounting records of company. Not a useful measure of its market value
Salvage value
Actual value of an asset at the end of its useful life. It is the expected selling price of a property when the asset can no longer be used productively by its owner
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Book Value Let: P = adjusted cost basis BVt = book

Book Value

Let:
P = adjusted cost basis
BVt = book value at the

end of period t
Dt = depreciation during period t
Then:
BVt = BVt-1 – Dt
BVt = P - ∑jt=1 Dt
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Capital versus expense Consider a copy shop, which buys: Ink and

Capital versus expense

Consider a copy shop, which buys:
Ink and paper
Copying (Xerox)

machines
Ink and paper are used up when they are bought (for all practical purposes):
Treated as an expense
When company buys/uses $1000 of paper,
It is $1000 poorer (not counting any revenue)!
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Capital versus expense Copying (Xerox) machines are used up only slowly

Capital versus expense

Copying (Xerox) machines are used up only slowly over

time:
Treated as “capital goods”
When company buys a $1000 machine
It trades $1000 cash for $1000 in equipment
Not poorer at all! (assets just changed form)
That is why expenses can be deducted from the income fully and instantly, assets or capital need to be depreciated
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Definitions Capital gains: Item selling price greater than purchase price Depreciation

Definitions

Capital gains:
Item selling price greater than purchase price
Depreciation recapture:
Item selling price

greater than book value
(Up to purchase price)
Taxed as ordinary income
Capital loss:
Item sold for less than book value
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Example If at the end of 1 year I go out

Example

If at the end of 1 year
I go out of business

and sell my tools for $40K.
I bought them for $35K and Book Value=$25
How much capital gain (or loss) do I have?
If at the end of 5 years
I go out of business and sell my tools for $5K
I bought them for $35K and Book Value=$10
How much capital gain (or loss) do I have?
Note that book value may be 0 even when market value is positive!
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Salvage value If a salvage value is expected, Depreciation applies to

Salvage value

If a salvage value is expected,
Depreciation applies to P -

SV
Example:
If P = $35K and I expected $5K salvage value in year 5,
I would depreciate $30K over 5 years
(only $6K per year)
That is, ($35K-$5K)/5 instead of $35K/5
Ending book value would be $5K
No capital gain/loss unless real salvage value differs
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Depreciation and taxes Depreciation is treated as an expense (i.e., a

Depreciation and taxes

Depreciation is treated as an expense
(i.e., a tax deduction)

in computation of income taxes
It is a fictitious expense!
No cash changes hands
Would you rather have that “expense” occur sooner or later?
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Observations Depreciation methods are conventions Not based strictly on market value!

Observations

Depreciation methods are conventions
Not based strictly on market value!
Different types of

assets have:
Different recovery periods
(Only partially related to actual lifetime)
Different allowable depreciation schedules
(Usually codified in lookup tables)
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Some Depreciation Schedules Straight line method (SL) Declining Balance method (DB)

Some Depreciation Schedules

Straight line method (SL)
Declining Balance method (DB)
Double Declining

Balance (DDB)
There are more schedules used
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SL Depreciation Constant rate of loss in the value of an

SL Depreciation

Constant rate of loss in the value of an asset


Graphically: straight line between the first cost and the salvage or scrap value of the asset

0

8

200

800

Years

Book Value ($)

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SL depreciation Recovery period = n Depreciation rate = 1/n (Same

SL depreciation

Recovery period = n
Depreciation rate = 1/n
(Same for all years!)
It

depreciates (1/n)% each year
SL Depreciation = (first cost - salvage)/n
(Same in all years)
Book value in period (t)
= book value in period (t-1) – depreciation(t)
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SL Depreciation – Cont. Dsl(t) = (P-SV) / N Dsl(t): depreciation

SL Depreciation – Cont.

Dsl(t) = (P-SV) / N
Dsl(t): depreciation for period

t
P: purchase value
SV: salvage value
N: useful life of the asset
BVsl(t) = P - t [(P-SV) / N] = P-t * Dsl
BVsl(t): book-value at the end of period t
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Example 1 Small computers purchased by a company cost $7000 each.

Example 1

Small computers purchased by a company cost $7000 each. Past

records indicate that they should have a useful life of 5 years, after which they will be disposed of, with no salvage value. Determine:
The depreciation charge during year 1
The depreciation charge during year 2
The book value of the computers at the end of year 3
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Example 1 – Cont. Dsl(1) = Dsl(2) = 7000 / 5

Example 1 – Cont.

Dsl(1) = Dsl(2) = 7000 / 5 =

$1400
BV(3) = 7000 – 3 [7000 / 5] = $2800
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Example 2 A machine tool has: First cost $35,000 Recovery period

Example 2

A machine tool has:
First cost $35,000
Recovery period 20 years
(based

on estimated life)
Estimated salvage value $3,500
Depreciation = ($35,000 - $3,500)/20
= $1,575 (same in all years)
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In table form … BV in year n = 1st cost – (SL Deprec)*n

In table form …

BV in year n = 1st cost –

(SL Deprec)*n
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Straight line depreciation Writes off capital investment linearly Estimated salvage value

Straight line depreciation

Writes off capital investment linearly
Estimated salvage value is considered:
Only

estimated!
Actual (future) salvage value is not known when depreciation schedule is set
SL Depreciation gives you a constant amount each year
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Declining Balance Depreciation Sometimes called constant percentage method or Matheson formula:

Declining Balance Depreciation

Sometimes called constant percentage method or Matheson formula: assumes

that the annual cost of depreciation is a fixed percentage of the BV at the beginning of the year
Constant proportion loss in value of an asset
Depreciation rate: a constant percentage
Ddb (t) = BVdb(t - 1) × d
Ddb (t): depreciation amount in period t
BVdb (t): book value at the end of period t
P: purchase price
d: depreciation rate
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DB Depreciation D(1) = P × d D(2) = d ×

DB Depreciation

D(1) = P × d
D(2) = d × (P- D(1))

= P(1-d) × d
D(3) = d × (P- D(1)-D(2)) = P(1-d)2 × d
…
…
Ddb (t) = P(1-d)t-1 × d
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DB Depreciation D1 = P × d Ddb (t) = P(1-d)t-1

DB Depreciation

D1 = P × d
Ddb (t) = P(1-d)t-1 × d
Ddb

(t) = BVdb(t - 1) × d
BVdb(t) = BVdb(t-1) - Ddb(t) = BVdb(t-1) (1-d)
BVdb(t) = P(1-d)t
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Example 3: Example 1 revisited Use a depreciation rate of 40%

Example 3: Example 1 revisited

Use a depreciation rate of 40% for

declining-balance method. Consider the previous example 1
Ddb(1) = BV(0) * (0.4) = 7000 (0.4) = $2800
Ddb(2) = BV(1) * (0.4) = (7000–2800) (0.4)
Ddb(2) = $1680
BVdb(3) = 7000 (1-0.4)3 = $1512
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Double declining balance (DDB) Most common form of declining balance is

Double declining balance (DDB)

Most common form of declining balance is double

declining balance or 200% declining balance (it would have been the triple and more, if the law permitted it, but the double was the maximum rate allowed):
d = 2/n, where n = recovery period
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Example 4: example 2 revisited Consider the same machine tool d

Example 4: example 2 revisited

Consider the same machine tool
d =

2/20 years
= 10% per year (or 0.1)
Depreciation in year 1 = 0.1($35,000)
We use $35,000 since that is the BV in year 0
= $3,500 (versus $1,575 for straight line)
Depreciation in year 2
= 0.1 (BV in t-1)
= 0.1 ($35,000 - $3,500) = $3,150, etc.
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In table form

In table form

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DDB With Conversion to SL at the Most Desirable Time Since

DDB With Conversion to SL at the Most Desirable Time

Since DDB

does not use a value for Salvage, we have three possible scenarios at time of disposal:
Over depreciation: Book Value < Salvage Value. Tax savings realized early. Small gain upon sale of the asset and taxes on the gain.
Exact depreciation: Book value = Salvage value. There are no tax consequences upon sale of the asset.
Under depreciation: Book Value > Salvage Value. Did not deduct as much as you could have and lost tax savings.
To allow companies take advantage of all the depreciation charges they are entitled to, they can switch from DDB to straight line at the most favorable time.
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Example: DB Switching to SL SL Dep. Rate = 1/5 a

Example: DB Switching to SL

SL Dep. Rate = 1/5
a

(DDB rate) = (200%) (SL rate)
= 2/5

Depreciation Base $10,000
Salvage Value 0
Depreciation 200% DB
Depreciable life 5 years

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(a) Without switching (b) With switching to SL Note: Without switching,

(a) Without switching

(b) With switching to SL

Note: Without switching, we have

not depreciated the entire cost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits.

Case 1: S = 0

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Case 2: S = $2,000 Note: Tax law does not permit

Case 2: S = $2,000

Note: Tax law does not permit us

to depreciate assets below
their salvage values.
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Sum-of-Years’ Digits (SYD) Method Principle Depreciation concept similar to DB but

Sum-of-Years’ Digits (SYD) Method

Principle
Depreciation concept similar to DB but with

decreasing depreciation rate.
Charges a larger fraction of the cost as an expense of the early years than of the later years.
Formula
Annual Depreciation
Book Value

where SYD=N(N+1)/2

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Example 10.7 – SYD method D1 D2 D3 D4 B1 B2

Example 10.7 – SYD method

D1

D2

D3

D4

B1

B2

B3

B4

B5

$10,000

$8,000

$6,000

$4,000

$2,000

0

0 1 2

3 4 5

Total depreciation at end of life

P = $10,000
N = 5 years
S = $2,000
SOYD = 15

n

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Units-of-Production Method Principle Service units will be consumed in a non

Units-of-Production Method

Principle
Service units will be consumed in a non time-phased

fashion (decrease in value of property is a function of use and not function of time)
Formula
Dper unit =
Estimated lifetime production units
See Example 7-4
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See Example 7-4 A piece of equipment used in a business

See Example 7-4

A piece of equipment used in a business

has a basis of $50.000 and is expected to have a $10.000 SV when replaced after 30.000 hours of use. Find its depreciation rate per hour of use, and find its BV after 10.000 hours of operation.
Solution
Depreciation per unit of production = ($50.000-$10000)/30.000 hours = $1.33 per hour
After 10.000 hours BV = $50.000 - $1.33*(10.000 hours) = 36.700
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Depletion Two methods of natural resource depletion Cost or factor depletion Percentage depletion

Depletion

Two methods of natural resource depletion
Cost or factor depletion
Percentage

depletion
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Cost Depletion Depletion is computed on a per unit basis Per

Cost Depletion

Depletion is computed on a per unit basis
Per unit amount

is determined by dividing the basis of the resource (FC) by the estimated recoverable units of resource
Number of units sold in year × per unit depletion = depletion for year
Total depletion can not exceed total cost of the property
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Cost Depletion: An Example Suppose a reservoir contains an estimated 1,000,000

Cost Depletion: An Example

Suppose a reservoir contains an estimated 1,000,000 barrels

of oil, and requires an initial investment of $7,000,000 to develop. Asume that 50,000 barrels of oil are produced annually
Unit Depletion Rate = 7,000,000/1,000,000 = $7 per barrel
Depletion Charge = 50,000 (7) = $350,000
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Percentage Depletion Percentage depletion Depletion is computed by using the statutory

Percentage Depletion

Percentage depletion
Depletion is computed by using the statutory

percentage rate for the type of resource
Rate is applied to the gross income from the property
Percentage depletion
Percentage depletion cannot exceed 50% of the taxable income (before depletion) from the property
Percentage depletion reduces basis in property
However, total percentage depletion may exceed the total cost of the property
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Percentage Depletion Allowances for Mineral Properties

Percentage Depletion Allowances for Mineral Properties

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Percentage Depletion: An Example Assume in the previous (oil) example that

Percentage Depletion: An Example

Assume in the previous (oil) example that the

price for oil is $23 per barrel and the expenses to produce oil (apart from the initial cost) are $380,000
Gross Depletion Income = 50,000*23 = $1,150,000
Depletion Rate = 22%
Percentage Depletion Charge = $253,000
Now check if that amount exceeds the maximum depletion charge allowed by law
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Percentage Depletion: An Example Gross Depletion Income = $1,150,000 Less expenses

Percentage Depletion: An Example

Gross Depletion Income = $1,150,000
Less expenses = -

$380,000
$770,000
Deduction Limitation 50%
Maximum Depletion Charge $385,000
$253,000 < $385,000, so full charge is allowable
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Agenda for today We will learn how to determine: Before-tax cash

Agenda for today

We will learn how to determine:
Before-tax cash flows
Taxable

income
Income taxes
After-tax cash flow
We will see the effects of depreciation schedule on after-tax IRR
Examples
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Agenda for today Review terms and definitions Rate of return (ROR)

Agenda for today

Review terms and definitions
Rate of return (ROR)
Tax deduction
Tax credit
Capital

gain/loss
Charity deductions
Bonds
Examples
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Why do we calculate depreciation? Since depreciation is an “expense” we

Why do we calculate depreciation?

Since depreciation is an “expense” we can

use that expense to reduce our taxable income, and therefore reduce the amount of taxes we pay.
We have to know how much our equipment has depreciated to determine the deductions to be made.
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Definitions Net versus gross income: Gross income = revenue or receipts

Definitions

Net versus gross income:
Gross income = revenue or receipts
Net income =

revenue minus expenses
Corporate tax is on net income (profit)
Individual tax is on gross income
Income taxes are an additional expense
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How to calculate After-Tax Cash Flow? Determine before-tax cash flows (BTCF)

How to calculate After-Tax Cash Flow?

Determine before-tax cash flows (BTCF)
Determine taxable

income (TI):
Revenues – (depreciation & other expenses)
Compute income taxes (Tax):
(Taxable income) * (tax rate)
Determine after-tax cash flow (ATCF):
Before-tax cash flow - income taxes
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Taxable Income and Income Taxes (An Example)

Taxable Income and Income Taxes (An Example)

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General table … Assume first cost=120, revenue=32, SL dep, SV=0, tax=40%

General table …

Assume first cost=120, revenue=32, SL dep, SV=0, tax=40%

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Observations Land is capital Land purchase is not an expense! Land

Observations

Land is capital
Land purchase is not an expense!
Land sale proceeds are

not revenue!
Just convert cash assets into land, vice versa
Capital gains are revenue.
Income taxes are an additional expense
But the timing of this expense is critical!
Results can vary a great deal depending on the timing of depreciation
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Depreciation example (SL) Investment with depreciation Buy equipment for $110K for

Depreciation example (SL)

Investment with depreciation
Buy equipment for $110K for 10 years:
No

salvage value
Straight-line depreciation
Savings of $32K per year
Costs of $5.7K per year
Net savings of $26.3K per year
Tax is 40%
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Depreciation example (SL) SL Deprec. = (110-0)/10 = 11 Taxable income

Depreciation example (SL)

SL Deprec. = (110-0)/10 = 11
Taxable income = income

- depreciation
Depreciation is treated as an expense!
Rate of return (IRR) =
20.1% before taxes
12.9% after taxes
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Longer depreciation (25 years) What would you expect: Will IRR go

Longer depreciation (25 years)

What would you expect:
Will IRR go up

or down?
I am extending the depreciation and paying more taxes sooner.
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Comparison 10 year (SL) depreciation schedule: Rate of return 20.1% before

Comparison

10 year (SL) depreciation schedule:
Rate of return
20.1% before taxes,
12.9% after

taxes
25 year (SL) depreciation schedule:
After-tax rate of return = 9.5%
Why is it less?
What happens to after-tax rate of return?
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Accelerated depreciation 7 year depreciation lifetime: Double declining balance for 4

Accelerated depreciation

7 year depreciation lifetime:
Double declining balance for 4 years
Followed

by straight line for 3 years
What would you expect:
Will IRR go up or down?
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Accelerated depreciation

Accelerated depreciation

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Accelerated depreciation How to figure out after-tax IRR? Use column for

Accelerated depreciation

How to figure out after-tax IRR?
Use column for after-tax cash

flow (just that column!)
Calculate IRR as usual
After-tax IRR = 14.7%
Tax benefit of depreciation accelerated,
So after-tax IRR went up (>12.9%)
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Net Income vs. Cash Flow Net income is an accounting means

Net Income vs. Cash Flow

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. That is why cash flows are relevant data to use in project evaluation.
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Why Do We Use Cash Flow in Project Evaluation? Example: Both

Why Do We Use Cash Flow in Project Evaluation?

Example: Both companies

(A & B) have the same amount of
net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period.
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Example: Cash Flow vs. Net Income

Example: Cash Flow vs. Net Income

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

Net income versus net cash flow

Net cash flows = Net income

+ non-cash expense (depreciation)
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Definitions Tax deduction: Expense deducted from taxable income Saving = (deduction)

Definitions

Tax deduction:
Expense deducted from taxable income
Saving = (deduction) x (tax rate)
Savings

are not equal to deductions, just a %
Tax credit:
Expense deducted from taxes
Saving = 100% of tax credit
Tax exemption:
Income that is not taxable
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Definitions Book value: Purchase price (for land, stocks, other non-depreciable assets)

Definitions

Book value:
Purchase price
(for land, stocks, other non-depreciable assets)
Depreciated value
(for

physical assets, patents, other depreciable assets)
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Definitions Capital gains: Item selling price greater than purchase price Depreciation

Definitions

Capital gains:
Item selling price greater than purchase price
Depreciation recapture:
Item selling price

greater than book value
(Up to purchase price)
Taxed as ordinary income
Capital loss:
Item sold for less than book value
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Capital gain/loss Generally attributed to year of sale Long-term capital gains

Capital gain/loss

Generally attributed to year of sale
Long-term capital gains (> 1

year)
Can be taxed less than ordinary income
Capital loss not deducted from income:
Only from capital gains (for companies)
Losses can be carried over to future years!
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Capital gain/loss Carrying backward or forward: Some businesses are very volatile

Capital gain/loss

Carrying backward or forward:
Some businesses are very volatile
E.g., oil prospecting!
Some

years may have net losses
Can use past losses to offset future gains
Can carry forward for up to 5 years
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Example Investment with depreciation Buy equipment for $110K for 10 years: No salvage value Straight-line depreciation

Example

Investment with depreciation
Buy equipment for $110K for 10 years:
No salvage value
Straight-line

depreciation
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Example Sell for $30K in year 8: Book value = $22K

Example

Sell for $30K in year 8:
Book value = $22K
Depreciation recapture =

$8K
Sell for $20K in year 8:
Capital loss = $2K
Cannot deduct from ordinary income
Deduct from gain (now or in another year)
Слайд 85

Non-depreciable example Investment with no depreciation Buy land for $110K Sell

Non-depreciable example

Investment with no depreciation
Buy land for $110K
Sell for $130K:
Capital gain

= $20K
Sell for $100K:
Capital loss = $10K (offset against gains)
Note: with land there can’t be Depreciation Recapture. Why?
Слайд 86

Capital gain/loss Taxable income = Gross income (i.e., revenues or receipts)

Capital gain/loss

Taxable income =
Gross income (i.e., revenues or receipts)
Minus operating

expenses
Minus depreciation
Plus depreciation recapture
Plus capital gains
Minus capital losses
(up to size of capital gains, but no greater)
Слайд 87

Personal income tax Same general issues as corporate tax: Tax exempt

Personal income tax

Same general issues as corporate tax:
Tax exempt income
(E.g.,

government bonds)
Tax deductions
(E.g., charitable donations, interest payments)
Слайд 88

Tax-exempt example Purchase $5K bond (20 years) From phone company at

Tax-exempt example

Purchase $5K bond (20 years)
From phone company at 11%:
$550/year, paid

as $275 every 6 months
Municipal bond from …. at 7.5%:
$375/year, paid as $187.50 every 6 months
Assume a tax rate:
tax rate = 33.8%
Слайд 89

Tax-exempt example Phone company bond at 11%: $550/year, paid as $275

Tax-exempt example

Phone company bond at 11%:
$550/year, paid as $275 every 6

months
Tax = ($550) x (33.8%) = $185.9
After-tax income
$550 - $185.9 = $364.10
Municipal bond at 7.5% (tax exempt):
$375/year (after-tax income greater!)
Слайд 90

Observation A government bond (tax-exempt) at 7.5% may give higher income

Observation

A government bond (tax-exempt) at 7.5% may give higher income than

a private 11% bond!
Desirability will vary with income:
Higher income gives higher tax rate
Tax exemption becomes more desirable
Слайд 91

Charitable deduction example Assume the following tax rate: tax rate =

Charitable deduction example

Assume the following tax rate:
tax rate = 38.4%
Charitable gift

of $1000:
Tax deduction = ($1000) x (38.4%) = $384
True cost of gift = $1000 - $384 = $616
Government is encouraging charity!
Слайд 92

Graduated income tax Constant tax rate: “Flat tax” If tax rate

Graduated income tax

Constant tax rate:
“Flat tax”
If tax rate is not constant:
“Graduated”

income tax
Слайд 93

Graduated income tax Example: 15% if taxable income $7.5K + 25%

Graduated income tax

Example:
15% if taxable income < $50K
$7.5K + 25% of

amount above $50K
If taxable income between $50K and $75K
$13.75K + 34% of excess over $75K
If taxable income > $75K
Слайд 94

Example - Corporate Income Taxes Facts: Capital expenditure $100,000 (allowed depreciation)

Example - Corporate Income Taxes

Facts:
Capital expenditure $100,000
(allowed depreciation) $58,000
Gross Sales revenue $1,250,000
Expenses:
Cost

of goods sold $840,000
Depreciation $58,000
Leasing warehouse $20,000
Question: Taxable income?
Слайд 95

Example - Corporate Income Taxes Taxable income: Gross income $1,250,000 -

Example - Corporate Income Taxes

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
Слайд 96

Average tax rate: Total taxes = $112,730 Taxable income = $332,000

Average tax rate:
Total taxes = $112,730
Taxable income = $332,000
Marginal tax rate:
Tax rate that

is applied to the last dollar earned = 39%

Example - Corporate Income Taxes

Слайд 97

U.S. Corporate Tax Rate (2001) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000

U.S. Corporate Tax Rate (2001)

Taxable income
0-$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 rate
15%
25%
34%
39%
34%
35%
38%
35%

Tax computation
$0 +

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

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

Слайд 98

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

Marginal and Effective (Average) Tax Rate for a Taxable Income of

$16,000,000
Слайд 99

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

How to Determine Income Tax Rate to be Used in Economic

Analysis?
Слайд 100

Incremental Income Tax Rate Average tax rate 17.86% 20.94% 31.75% 0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%

Incremental Income Tax Rate

Average tax rate 17.86% 20.94% 31.75%

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

= 31.75%
Слайд 101

$0 $20,000 incremental taxable income due to undertaking project

$0

$20,000 incremental
taxable income due to
undertaking project

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