After-tax rate of return

Various provisions m the federal income tax treat energy producers more or less favorably than other businesses. By changing the after-tax rate of return on investments in the energy sector, the Tax Code may alter the long-run supply of specific types of energy. 

There also are circumstances where income tax provisions reduce the after-tax rate of return on such investments below those available in other sectors. For example, certain types of electricity-generating property (such as those used in distributed power applications) may have useful lives that are substantially shorter than the tax lives permitted for cost recovery. In such instances, the after-tax rate of return will be negatively affected by these specific provisions. 

The federal income tax on profits from corporations is based on income after all costs, including depreciation, have been deducted. Because depreciation affects taxable income, it is an important consideration in estimating profitability. The federal income tax rate for large corporations (profit greater than 75,000) was recently roughly 34-35 percent. State income taxes may push the total tax rate to about 40 percent. Therefore as an expense a depreciation amount of 1 reduces taxes about 0.40. At this level of taxation, the before-tax rate of return will be roughly 1.67 times the after-tax rate of return. 

It is now possible to compute the after-tax rate of return, which is the net annual profit after tax, divided by the total capital investment (fixed capital costs plus working capital), multiplied by 100. In the case presented here, the after-tax rate of return is 18.16%. 

Usually, an after-tax rate of return on the initial investment of at least 30% is desirable. The method used to arrive at a rate of return is discussed below. An annual after-tax cash flow can be computed as the annual revenues (R) less the annual operating costs (AOC) and less total income taxes (IT). Total income taxes can be estimated at 50% (this number could be lower subject to the passage of the new tax laws) of taxable income (TI). 

FIG. 9-1 Relationship between annual costs, annual profits, and cash flows for a project. A d — annual depreciation allowance Acf — annual net cash flow after tax Ac/ = annual cash income Age = annual general expense Aqp = annual gross profit A/r = annual tax A e = annual manufacturing cost Avc/ = annual net cash income Avvp = annual net profit after taxes A/ p = annual net profit As = annual sales Apc = annual total cost (DCFRR) = discoiinted-cash-flow rate of return (NPV) = net present value. 

The fractional interest rate of return based on the net annual profit after tax and the original investment is... 

FIG. 9-6 Effect of straight-line depreciation on rate of return for a project. Abd — annual depreciation allowance A c/ = annual net cash income after tax Awwp = annual net profit after payment of tax Cj = total capital cost. 

Both methods assume that the money earned can be reinvested at the nominal interest rate. Suppose the rates of return calculated are after tax returns and the company is generally earning a 5% or 6% return on investment. Is it reasonable to expect that all profits can be reinvested at 23% or even 20% No, it isn t Yet this is what is assumed in the Rate of Return method. Sometimes the rate of return may be as high as 50%, while a reasonable interest rate is less than 15%. Therefore if a reasonable value for the interest rate has been chosen (this is discussed later in this chapter) and the two methods differ, the results indicated by the Net Present Value method should be accepted. 

One source21 states that a 20% return after taxes is a minimum for some companies. Obviously the expansion of a well-established chemical line like sulfuric acid or chlorine has less risk and hence will require a lower rate of return. 

The same assumptions are made as those given above for the net present value calculations. The rate of return is 13.3% after taxes. 

Three projects (A, B, C) all earn a total of 125,000 over a period of 5 years (after-tax earnings, nondiscounted). For the cash-flow patterns shown in the table, predict by inspection which project will have the largest rate of return. Why ... 

Suppose that an investment of 100,000 will earn after-tax profits of 10,000 per year over 20 years. Due to uncertainties in forecasting, however, the projected after-tax profits may be in error by 20 percent. Discuss how you would determine the sensitivity of the rate of return to an error of this type. Would you expect the rate of return to increase by 20 percent of its computed value for a 20-percent increase in annual after-tax profits (i.e., to 12,000) ... 

The longer it takes to build a facility, the lower its rate of return. Formulate the ratio of total investment I divided by annual cash flow C (profit after taxes plus depreciation) in terms of 1-, 2-, and 3-year construction periods if i = interest rate, and n — life of facility (no salvage value). 

Assume that the plant in which this equipment is installed will operate 10 years, that a tax rate of 34%/year is applicable, and that a charge of 10% of the capital cost per year for depreciation will be employed over the entire 10-year period, that fixed charges including maintenance incurred by installation of this equipment will amount to 10%/year of the investment, and that a minimum acceptable return rate on invested capital after taxes and depreciation is 15%. Determine which of the two alternative installations should be selected, if any. 

Suppose project C has a 20-year life and a yearly after-tax cash flow of 48,000 for an initial investment of 300,000. Project D has a 5-year life, with a yearly cash flow of 110,000 for an initial investment of 300,000. Compare the internal rate of return and net present value (for i = 0.08) for each option. 

Inflation can be a significant factor in analysis of profitability. High inflation rates frequently occur in many countries. In computing the rate of return or net present value, you need to obtain a measure of profitability that is independent of the inflation rate. If you inflate projections of future annual income, the computed rate of return may largely result from the effects of inflation. Most companies strive for an internal rate of return (after taxes) of 10-20 percent in the absence of inflation ... 

After eight years, Lavoisier calculated the rate of return on his investment. It was less than 5 percent. He concluded that this was no doubt the reason that the well-off farmers living near Paris who manage to save some money prefer to place it in public loans and funds rather than use it for the improvement of agriculture. There was another obstacle to improvement, too, Lavoisier noted the tax... 

Discounted Cash Flow In the discounted cash flow method, all the yearly after-tax cash flows are discounted or compounded to time zero depending upon the choice of time zero. The following equation is used to solve for the interest rate i, which is the discounted cash flow rate of return (DCFROR). 

Detailed estimates similar to Table XIX were carried out for each case. The results are summarized and compared on Table XX. Factors used for labor, maintenance, taxes, and insurance are typical of those used for analyzing long-term, large scale commercial projects. The capital charge factor, the yearly rate at which the investment is charged to the project, was chosen to provide about a 15% after-tax discounted cash flow (DCF) rate of return on investment based on reasonable and commonly used assumptions for projects of this type and magnitude. These assumptions are summarized on Table XVIII. 

To determine the required selling price of hydrogen, a cash flow analysis was performed using an after-tax internal rate of return (IRR) of 15%. Other major assumptions used in the analysis were equity financing for a 20 year plant life including two years of construction time, a 90% on-stream factor with 50% plant capacity in first year of production, 30% of capital investment is spent in the first year and 70% in the second year, a tax rate of 37%, and ten year straight-line depreciation. 

The method of approach for a profitability evaluation by discounted cash flow takes into account the time value of money and is based on the amount of the investment that is unretumed at the end of each year during the estimated life of the project. A trial-and-error procedure is used to establish a rate of return which can be applied to yearly cash flow so that the original investment is reduced to zero (or to salvage and land value plus working-capital investment) during the project life. Thus, the rate of return by this method is equivalent to the maximum interest rate (normally, after taxes) at which money could be borrowed to finance the project under conditions where the net cash flow to the project over its life would be just sufficient to pay all principal and interest accumulated on the outstanding principal. 

Designate the discounted-cash-flow rate of return as i. This rate of return represents the after-tax interest rate at which the investment is repaid by proceeds from the project. It is also the maximum after-tax interest rate at which funds could be borrowed for the investment and just break even at the end of the service life. 

Net cash flow represents the difference between all cash revenues and all cash expenses with taxes included as a cash expense. Thus, discounted-cash-flow rate of return and present worth should be calculated on an after-tax basis, unless there is some particular reason for a pretax basis, such as comparison to a special alternate which is presented on a pre-tax basis. 

The information given in Prob. 2 applies to conditions before income taxes. If 34 percent of all profits must be paid out for income taxes, determine the standard rate of return after taxes using the figures given in Prob. 2. 

An investment of 1,000,000 will give annual returns as shown in the following over a life of five years. Assume straight-line depreciation, negligible salvage value, and 34 percent income taxes. What is the discounted-cash-flow rate of return on the investment (Profitability Index) before and after taxes with (a) No inflation and annual returns of 300,000 each year (i.e., cash flow to the company of 300,000) before taxes ... 

A) The case where the company demands a 20 percent continuous nominal interest rate of return after taxes on any investment [i.e., profitability index (r) is 20 percent]. 

The sum of these discounted NCEs over the life of the project is the project s net present worth. The project with the highest positive net present worth would be the one selected. The discount rate used in Eq. (18.5) is the firm s marginal acceptable rate of return (MARR) for anticipated projects or its hurdle rate. Note that the discount rate is expressed on an after-tax basis to be consistent with the NCF. Also, when comparing projects via the present worth method, all projects must have equal... 

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