Income-tax effects

Although most companies use only revenue and expense figures when comparing investment projects, income-tax effects can enter into each calculation if either revenues or expenses change from the baseline values. More expenses mean lower profits and fewer taxes, and vice versa. If a company needs to know the effect of income taxes on profit, the computations are simple and can be done during or after... 

Ignore income tax effects and depreciation to simplify the calculations. 

Methods for including the cost of capital in economic analyses have been discussed in Chap. 7. Although the management and stockholders of each company must establish the company s characteristic cost of capital, the simplest approach is to assume that investment of capital is made at a hypothetical cost or rate of return equivalent to the total profit or rate of return over the full expected life of the particular project. This method has the advantage of putting the profitability analysis of all alternative investments on an equal basis, thereby permitting a clear comparison of risk factors. This method is particularly useful for preliminary estimates, but it may need to be refined further to take care of income-tax effects for final evaluation. 

Example 1 Determination of rate of return on investment-consideration of income-tax effects. A proposed manufacturing plant requires an initial fixed-capital investment of 900,000 and 100,000 of working capital. It is estimated that the annual income will be 800,000 and the annual expenses including depreciation will be 520,000 before income taxes. A minimum annual return of 15 percent before income taxes is required before the investment will be worthwhile. Income taxes amount to 34 percent of all pre-tax profits. 

Income-tax effects can be included properly in all the profitability methods discussed in this chapter by using appropriate definitions of terms, such as those presented in Table 4. The methods of discounted-cash-flow rate of return and present worth are limited to consideration of cash income and cash outgo over the life of the project. Thus, depreciation, as a cost, does not enter directly into the calculations except as it may affect income taxes. 

Mr. Treyz feels he can sell 6000 lb of PE per day at the present market price. He can also sell 100,000 lb of formalin per day, but he is willing to make the new investment if it will give him better than a 30 percent yearly return on the PE initial plant investment. Ignore income-tax effects and working capital. 

Incineration, 88-89 Income statemenf 142-145 Income-tax effects on cost of capital, 248-249 on optimum economic pipe diameter, 366-367 on profitability evaluation, 300, 324... 

In addition to specific deductions and credits, the Tax Code permits state and local governments to issue bonds on which the interest is exempt from federal income tax. This provision means that states and local governments can borrow at interest rates below those paid by private corporations. Municipally owned electricity providers often can issue tax-exempt debt the lower interest rate may have the effect of increasing the provision of electricity by these entities. 

Tax policy (including excise taxes and income tax provisions) operates in several different ways to affect energy supply and demand, for energy in general and for specific fuels. There is no consensus about the net overall effect on supply and demand, in part because th ese provisions operate in different sectors, in different markets, and sometimes in different directions. 

The determination of the present value for the depreciation plans is one of the best ways of comparing depreciation plans. In calculating the present value it will be assumed that depreciation expenses remain in the company and effectively reduce income taxes. If the income tax rate on earnings is 48%, then the amount of income tax saved when depreciation expenses are increased by 100 is 48. Therefore, the net savings of including depreciation as an expense is 48% of all depreciation. If the net salvage value is less than the book value after depreciation, the difference is an income and is subject to taxation. Since the amount will be the same for each of the depreciation schemes, it will not be considered in comparing the different methods. 

The revenue from carbon taxes can be used into the economy to reduce income taxes or levies on labor or capital investment. This may be part of a national or international reform of the taxation systems with the effects to shift the tax burden from "goods" like labor to "bads" like pollution. 

Griest (1979) has discussed the effects of inflation on profitability analysis and has pointed out that the percentage change in profits after income taxes rarely increases at the rate of inflation, largely due to the effects of taxation. Assumptions about inflation can change the relative ranking of project alternatives based on net present value special techniques based on probability may be required because inflation is difficult to predict. 

If you plan to earn income after retiring, you need to look carefully at the net effect of your earnings on your overall tax bill and plan your income to minimize any adverse effect. In addition to the graduated schedule of federal and state income taxes, consider the effect of earnings on Social Security benefits and the cost of self-employment tax. 

The strength of the temperance movement in overcoming economic realities of the day is illustrated by the effect the Eightieth Amendment had on the collection of fees by the Internal Revenue Service (IRS). In 1916, gross receipts at the IRS were 513 million, of which 241 million were derived from distilled spirits and fermented liquors. Thus, 47 percent of IRS receipts were from alcohol-related income versus 13 percent from personal income tax. The movement s fervor also affected the medical profession. With the cynical belief that physicians would discharge their responsibilities under prohibition no better than they had under the Harrison Act, new legislation was created. The specific law, the Willis-Campbell Act of 1921, was enacted in order to restrict the number of liquor prescriptions permitted by each physician. 

The national government has many regulations and restrictions which have a direct effect on industrial costs. Some examples of these are import and export tariff regulations, restrictions on permissible depreciation rates, income-tax rules, and environmental regulations. 

The effect of high income-tax rates on the cost of capital is very important. In determining income taxes, interest on loans and bonds can be considered as a cost, while the return on both preferred and common stock cannot be included as a cost. Since corporate income taxes can amount to more than half of the gross earnings, the source of new capital may have a considerable influence on the net profits. 

The total investment required for a new chemical plant is estimated at 2 million. Fifty percent of the investment will be supplied from the company s own capital. Of the remaining investment, half will come from a loan at an effective interest rate of 8 percent and the other half will come from an issue of preferred stock paying dividends at a stated effective rate of 8 percent. The income-tax rate for the company is 30 percent of pre-tax earnings. Under these conditions, how many dollars per year does the company actually lose (i.e., after taxes) by issuing preferred stock at 8 percent dividends instead of bonds at an effective interest rate of 6 percent ... 

It has been proposed that a company invest 1 million in a venture which will yield a gross income of 1 million per year. The total annual costs will be 800,000 per year including interest on the total investment at an annual rate of 8 percent. In an alternate proposal, the company can invest a total of 600,000 and receive annual net earnings (before income taxes) of 220,000 from the venture. In this case, the net earnings were determined on the basis of no interest costs. The company has 1 million of its own which it wishes to invest, and it can always obtain an effective 6 percent annual interest rate by loaning out the money. What would be the most profitable way for the company to invest its 1 million ... 

The effects of income taxes should be considered when making a final decision regarding insurance. Because the premiums for standard insurance are tax-deductible, the actual cost after taxes for the protection may be much less than the direct premium charge. Another advantage of standard insurance is the inspection services supplied by the insurance companies. These companies require periodic inspections by specialists to make certain that the insurance rates are adequate, and the reports of these inspectors often indicate new ideas or methods for increasing the safety of the operation. 

The company in charge of the plant demands at least a 10 percent annual return based on the initial investment for any unnecessary investment. Only one of the four designs can be accepted. Neglecting effects due to income taxes and the time value of money, which (if any) of the four designs should be recommended ... 

For the typical situation of an industrial operation which has been designed to produce a set number of units per year which will be sold at the prevailing price, there would be no special problem with handling inflation except for the influence of income taxes. If the inflationary costs are considered as having the same effects on the selling price of the product as on the costs for the operation, then return on investment before taxes is the same whether or not inflation is... 

In making the investment comparison, ignore working capital and consider only the FCI with an annual charge for depreciation of 8 percent of FCI. Assume all operating costs except those for raw materials and depreciation are constant for the two conversion cases under consideration. Do not consider effects of income taxes. 

The discount rate is a weighted average cost of capital (WACC) and takes into account the capital structure of firms, cost of equity and debt, and income taxes. The capital structure of firms is assumed to be 30% equity and 70% debt. The cost of equity capital is 10%, the cost of debt is 7%, and the effective income tax rate is 39%. The debt instrument is assumed to be a 20 year, 7% coupon bond. The calculation of the discount rate is... 

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