This preview shows pages 1–3. Sign up to view the full content.
M I M E
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 periodbyperiod approach, or with tax factors.
In the periodby
period approach, aftertax 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 the profile of cash flows.
Spreadsheet software is most suited to this approach.
In the second approach, tax factors are
applied to convert the project's beforetax estimates to aftertax values.
The desired indicators
can then be determined from these aftertax values in combination with appropriate time value
factors.
In particular circumstances, tax factors often provide a quicker and much simpler
approach to solving a problem.
However, caution should taken with this approach, because tax
factors contain particular builtin 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 periodbyperiod approach
becomes necessary.
Only one approach should be used at a time, otherwise, doublecounting may occur.
For
instance, tax payments or savings should be based on the beforetax components of a project,
and not on the aftertax components derived from the application of tax factors.
As well, the
periodbyperiod approach may still necessitate the use of tax factors under particular circum
stances.
In the Canadian tax system for instance, the capital tax factor is a convenient way of
handling tax credits that extend beyond a project's life when assets are depreciated by the
decliningbalance method.
With practice, the problemsolver will learn to recognize the more suitable approach.
1.
i)
Using the estimates as given, i.e. on a beforetax basis, the rate of return is the discount
rate (r) that yields a net present value of zero.
NPV = 56 000 + 13 500 (P/A,r,7) = 0
Thus,
(P/A,r,7) = 56 000 / 13 500 = 4.1481
From the compound interest factor tables,
(P/A,15%,7) = 4.1604 and (P/A,16%,7) = 4.0386
By linear interpolation,
r = 15 + (4.1604  4.1481) / (4.1604  4.0386) = 15.1%
A financial calculator yields a value of 15.10%.
50
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document The beforetax rate of return is 15.1%.
ii)
The tax factor approach is used here.
The assumption that any tax allowances exceeding
the annual savings can be applied against other corporate income is compatible with the use of the
Capital Tax Factor.
OTF = 1  t = 1  0.45 = 0.55
This is the end of the preview. Sign up
to
access the rest of the document.
This note was uploaded on 04/25/2010 for the course MIME 310 taught by Professor Bilido during the Winter '08 term at McGill.
 Winter '08
 Bilido

Click to edit the document details