CH7 Solutions

CH7 Solutions - 306-310 ENGINEERING ECONOMY SOLUTIONS TO...

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1 3 0 6 - 3 1 0 E N G I N E E R I N G E C O N O M Y SOLUTIONS TO PROBLEM SET #7 – INCOME TAX CONSIDERATIONS I NTRODUCTORY COMMENT Most problems involving taxation can be solved by either one of two approaches, i.e., using a period-by-period approach, or with tax factors. In the period-by- period approach, after-tax cash flows are determined for every period of the project's life, using revenues, operating expenses, tax payments and capital expenditures. Appropriate tax regula- tions are applied for the purpose of determining tax payments. Then, the project's profitability and/or whatever other required indicators are determined from its time distribution of after-tax cash flows. Spreadsheet software is most suited to this approach. In the second approach, tax factors are applied to convert the project's before-tax estimates to after-tax values. The desired indicators can then be determined from these after-tax values in combination with appropriate time value factors. In particular circumstances, tax factors often provide a quicker and much simpler ap- proach to solving a problem. However, caution should taken with this approach, because tax factors contain particular built-in assumptions regarding the timing of tax savings. Therefore, they should only be used when these assumptions are correct and/or reasonable given the situa- tion. In cases when the assumptions are inappropriate, the longer period-by-period approach becomes necessary. Only one approach should be used at a time, otherwise, double-counting may occur. For instance, tax payments orsavings should be based on the before-tax components of a project, and not on the after-tax components derived from the application of tax factors. As well, the period- by-period approach may still necessitate the use of tax factors under particular circumstances. In the Canadian tax system for instance, the capital tax factor is a convenient way of handling tax savings that extend beyond a project's life when assets are depreciated by the declining- balance method. With practice, the problem-solver will learn to recognise the more suitable approach. 1. As depreciation allowances are based on the declining-balance method, the taxable income (operating profit less depreciation allowance), and thus, the tax payments, are not constant. Net income before allowances and taxes (NIBA): 15 000 000 - 7 000 000 = 8 000 000 Year NIBA Depreciation Allowance Taxable Income Taxes 45% After-tax Cash Flow Time 0 -25 000 000 1 8 000 000 7 500 000 500 000 225 000 7 775 000 2 8 000 000 5 250 000 2 750 000 1 237 500 6 762 500 3 8 000 000 3 675 000 4 325 000 1 946 250 6 053 750 4 8 000 000 2 572 500 5 427 500 2 442 375 5 557 625 5 8 000 000 1 800 750 6 199 250 2 789 663 5 210 337 6 8 000 000 1 260 525 6 739 475 3 032 764 4 967 236
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2 7 8 000 000 882 367 7 117 633 3 202 935 4 797 065 8 8 000 000 617 657 7 382 343 3 322 054 4 677 946 Totals 64 000 000 23 558 799 40 441 201 18 198 541 20 801 459 Note : At project completion, the capital expenditure has not been completely depreciated. The
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CH7 Solutions - 306-310 ENGINEERING ECONOMY SOLUTIONS TO...

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