Engineering Economics (2016 Textbook).pdf - CNAPTC 1.2 7 laxes fl9 Personal Income Taxes and Corporate Income Taxes Compared pjfl vicoine tases and

Engineering Economics (2016 Textbook).pdf - CNAPTC 1.2 7...

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Unformatted text preview: CNAPTC 1.2 7 laxes fl9 Personal Income Taxes and Corporate Income Taxes Compared pjfl vicoine tases and colporate iicutne uxe FIìee are cubumiaI dffeieiice Most duJt ii.c familiir with dic rouunc of filing incumc tax returns. For most pcopk, thc proccdurc is rithcr simpic: An cmploycr provides ì stnmcnt rcpordng thc person ncomc incarne tax aIrcidy pd, and othcr Jr1ounts for the prcvious )rcr. thcse amounts are assem1kd ou the tax trrn Mid hire Used cak-ulue ihe iotiI tax owed or the arnourt of refujiti. rUht: u returu ts then ubrniueti to the iproriate govennnent tx ageiicy fur rocessirig. Corporate taxes are inílir in corne ways, but the re are several substantial thftereiicec. Onc main Jiffcrcnce has to 10 with the tax racc. Pcrsonal rncomc txcs usually exhibit a progrc:s5i'c tZX YItC mcning that people who earn more arc charged a Iargcr percentage oíthcir incomc.. For exampic. ifa perso&s tax.ibk incxnnc is rcry Io' he or shc might flot pt' auy income taxcs. At a moderate iricorne in indviJuaI rrngti t he epectud to 25 percent ofhis or lier income s income tax. A very-high-income indivdua1 in some cowitríes might pay SD percent or more of his or her income in income tax. Although thc cact ratc of taxation changes from ycìr to year. and varies from country to councr individuiI income taxes in developed countrics arc almost always progressive. En contrs, corporac tixcs are typically Icvicd according to a proportíonl or tx. iliLs nietns that cororatioris pv he saine tax rate, regardless of their iiicorne level. Agún, races c-iì change over time atid between couiicries, but the r.ue will he the sgiie whcthcr a company makes a small profit or i vcry large profit. The main cxccption is that most councrics git-c smaller compatiics favourthlc ta rcatmcnc to encourage ncw businesses. I lowever, once the business is oEa certain size, the t:n ritc is constant. .&I1()thCT difference betweerk personal iticonie IIx ami coqiurite iucorne tX lia' to (IO with itr the LI-x IS calculiatetl_ l'he income Used to LletercnIc Ilie taxes ail iIl(Iiviilu;l pays not uet1 i reduced by deductions or tax credits, wllteh are real or nominal cocts that or are taxed at a reduced race. For cirnp1c, cxccss medical epcnscs, tuition kcs antI pcnsion plan concriburions arc gcncrailv all considcrcd eligible dcducaons along with a subtstandal 'basic personal amount." 'thus an individuaPs utaabIe income" cin be qrnte 3 hit tess i-fian his or her actual meome. A cororaiìoti's Laxes are calculated in quae a different mariner. Net liicorne br tax purposes is calculated by subtracting expenses, which are either real costs associated with performing the corporation1s business or a portion oí the capital epciisc for an from gross income. ConscqucntI; a company that m3Lcs lio prott (income iess epcnscs) may pay no income taxes. Final ly. aJILI corporale taxes differ in c(irnplexit In arcìcu1ar, a comparivs taxes will uualTy be complicated by iues concerning capital expenses. trhiclì are purchasts of asseL ci sígníficaiit ralue. Suth assets have a strong effect on the income taxes paid by a company but how they are created for tax purposes is complex. lhis is usually not an issue oconcern to indisduaIs. to asset1 7.3 Corporate Tax Rates In this diajaer. we are concerned only with coriorate taxes, and in particular tIle impact ofcorporate income taxes on the viabdicy oían engmeermg project. Thble 7.1 compares corporate taxes among several couinries, hut the actual tax rate applied in any circunistance can lic fairly complicated and can depend on the suc of the firm, whether it is a PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 240 CIIAPTIII ? Tucet Table 7.1 Corporate Tax Rates Around \rgentina \ucr1ia 8rai1 Canada 35% 30% 25% Germany India 34% Isracl 36.1% 25% 33.33% Chini Francc te World frcLrnct South Afrtca Cniid Kingdom Unitcd Staccs 25% 3t)-44J% 12.5% 31% 29% 15-5% location, and a varicty <Áotber ficcors. Comparing the ux nates in ulfferent countries s difficult. For example, come countries provide a ful! range of healthcare cervicec from their tax revenues, while others do uoc. Cercaiti health-care cot may be, msccad! a significant cxpensc for a compan In come countries thc tocal curportc tu is a combination offrderal tix and statc or provincial tar. 1c races cliangc ovcr ümc. and thcre arc sometimes hor-tcrni tax rcdlicnon5 or inccntwCs (see Ckse-Up 7I) for companies in sl)ecIìc iidutrie. Rather iban locucluig wi ilie irnIicaiions olsuch uIiïerencec, our concern here is wdi che basic approach used in deternuirng the impact of taxcs on a proicct. For spcciI tax rules, it is bcs o chcck with the approprîatc tax agency or a tax specialist. in the past lt is aiso .uto.ih noting thac: tax rules can changc cuduknl» For 3(_} years .1 icre jtare Ieen fundanicuital dun gts in the cororate tax ru1e in CanaLla and other countries. These changes can aiitl have had a significant impact on inveUneiics Tu ade by companies. Lesc-signilicant new rulec are ititroduced every yeardue to changes in techiOlo% current cconomic conditions, or policical factors. In particular thcrc arc usually opportunicics for small technoIokal companies co take advantage of benckial tax rules. as detailed in Cl0SC-1.J 7.2.. rnnuiacturcr. i cxampic1 Inetives I- - I Governments sometimes uy co iiitluence corporate hehaviour through the use. ot in«nzáves. These inccntivcs include grants to certain types of projcct; for cxample, prQjett$ unckrtaken in particular g«graphic areas, or nriectc provkli ng m iI ovnuent t( crtin categorics ui Oilier incentives take the kwnt of ta relief. For example, ieverI cuuntries allow poilutioiì equipnieni to be folk cpenscd in the rer of purchase. Tue ibility to depreciate poIliiori equIpment qiickly it a more desirible investmeiic for a company and a li,cncficial iflvtsrmcnt br society as a whoic. ì'he Cct Iorin of incentivc% changes from year co year as gnvernmcnts change and a rIte pliticl iritresb of r.00kty clunge. In rnat compuriies there is n individual or kparunent Lh1L keeps ir.ck of poible programs alkuing cirnipany protects. Incentives must be considercd when assessing the viahiliiiy ot project Grant meenIj%res provide additional cash How to dic project that n bc taken into account like any 1:10w other cish ckmcnt- Ta inccnovcs may lic morc di1icuh to ascss since somcimcs for ccimI1c. IlleV u-sc othcr tC)IThS of de1rcdatùrn or mîy rccult in diftcrent tax races ditrein prt ()ÍtIte pro ¡ecL PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CW*PTC Sriiall Company 7 laxes ?41 lax Rules d'rntiges arc gwen w sinì1ler compinic. ucb tediniciIIy oriented ..ridiig their own firm rather than working for a ti-g'er company. The purpoe ut these incentives is to give i strong motPv(ion to inco.rportc a new company and providc morc aftcr-u incomc for retnvesunent and ext)an!ion. ¡n Canada, die crnall bursess deduction applies tu small Canadian-controlled private corpora orl arid rcduccs ihc ellcctivc tax rate for a small Canadian company tu Special tx llfl-up. This iiiav ti i o xrticuLir intere;t to engiiieerc incerest«1 iii Li less than 20 percenc U die Spreidsliect Savvy fiawre will Fucus on che ue ufExcel charts and Ñn'matiing (iatrcs USC(Ul in the pnparation o(cnginecring reporis. Spread4ieet soFtware i.. in tool nr prcparing charts ta cumma nze the rcsailts rif n ccoriumk anaiysi. Creating charts with Eççl is qraiInarward. Pral,llv thc nwist commonly uscd is the X-V scatter) chart, lt pIot a sei-jcs ol V values a Ñnçtiun uf corrjin Jng X values. The atter chart below wjs ci-eaeç4 Ivotii the Chipicr $ Sprcadshcct Sawy tahlc in Clupters 7 antI RcpLwrmenl Analysis 50000 000 4 40000 35 000 30!'!' (5) 25 (MIRi 20 Iii;.! i 5 000 10 000 5 000 o 3 i 4 L'.. -s- Salar Iuc --- Operating and mintenanie costs fr Lue in \cars. Salvage Value, To beitin. highlight xlls R3D$ containing the titles and data Operating anti Maintenance CLs. Select Insert Irwn the riliixjn. and then X-Y(ccauer)as th desired chart type. Ofthc options, thc clurt alxwe shows 'srraìght mcc and markcr.' By default. the chart will be inserted as an 0bject intii thc current worksheet. }y tlicking anywhere on th chart. the riIbim will indiçatc three çhrt editing uptions I)CsiII1 I .ayout anj Formai. inder Dcsi-n, the layout and saylc of an cxisting chart ian he changcJ. as well a its location- Under th I.ayout tab iin the nbbmi. the lacauun of the legend was chand to below the chan, and the font wschangcd to enlarge it (i-oui ts dthoht aluc. Also undcr I.avuut. the grîdhineswcreajiiisted ti and I PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 242 CHAPTIII ? Tucet hiw both honzunul arid vcnìcal grid1inc! for the mar adJeI. a; well as both horíiontal and rnciÎ ¿is Iabe1. rai. on tI1IC auic mar1cr. FinaIly a charE t1c ws hcsc options all appear under the Layout rî1iiìfl. Thc lwmLring afrhc X and V axes was aIuchangcd. Whcn thc chart w-as firsi nudc, thc mticimum Y va!uc displaycd was 60 0(X), and far tlic X axis it ws 8)- Iioveiing ovir ithcr uf axes or rile AXLS Ic1 and righr-ctickini, scvcral cdiiing ripiions bccomc ava2tablc. ith thc (nnr option fur the Y acä, the dedmal points were removed and the funt suc cnlargcd to I 2pt ,riaI) md lEahcized. Under furtnat aiis, the maximum vahic di%played was %ct to 5O 000. Similar changes were o 4 and thc Ioi ic chngii tu i 2pt ÑI, itahmade to the X ci'i.., with the ma.iuiiwii luc Vith oruc pnictkc, mod find charts cized. ma!vctd to be a fact an1 eWectwc toal for cuninìanzìn . artd commuiiic.itint recuits from an 1.4 I Before- and After-Tax Txcs havc cmomk anaIvcic. MARR significant effect ori cngiincering decixion making so much so chat they cannot 1)C ignored. In this tct, so it seems as though no spectiv tix ciIculitions hwc been donc. In fact, they hare bccn implicitly incorporated into the computation5 iIrough the wie ()fI lieIure-ux MARR. iIlougtk we Iia not called it ucb. rIìe basic logic i a follows. Suiec taxes have the effect of redudtìg proñts asoctned with a project we need to make cure chat we sec an appropnate .\IARR for project accept3IJi1k) If we do not cxplicitly account for che impcc of cacc in thc project cash (1ows then WC fleed (t) Set !1ARR high enough to recognic thit taxes Will fleed to be paid. 1'his is the br/ire-t.íi.r \IARR. If. ou the other hand, the impact of taxes i explicitly cc()uI1tec1 nr in the t1owi ola roect (i.e, rtduce the ca,h flows I,y tx rate), then the MARR uced for the proiect chould bue lower, since che cas-h flows already taLe into account the paymcnc o caces. This is thc IftLSt.7?X 1ARR. lui íict, we caut expreM iui approximate re1aiionchtp ì lar1 1 ch (7.1) ARR1artx X (1 - t) where t is the corporate t rate. The tir'i,r_r4ix \1ARR means tIit the %1\RR has been chosen high enough tu provide an accepiable r.Ìte of return williout explicitly cousiLlering bixes. liii other words, since aU profiLs are axed at hie ra te hie l!ejoîr-tdx \1ARR bac to MARRTIU t, include enoug1 returns to meet the afkr sax i-1ARR and, addition, provide the amount to be paid in taxes. As we can sce front tbc ibovc equacion, the after-tax MARR will gcncrally be: lower than the bcforc-tax !-1ARR. %trc will sec latcr in this chapter how thc relationship giren in this equation is a simpIificition hut a reasonable approximation o1 the effect of taxes. In pracuce, the beÑre- rn LI after-tax 1ARRs are often chosen iudependenny and are not directly related by this equauon. Generally s-peaLtng, if a MARK is t.iven rjchout seciIvtn whether t is on a before- or after-tax hasic-, it can be assumed co bc i before-tax i\IARR. III Saskatchewan Gold Mines (SGM) has been selecting projects for inves-inient on the basis of a before-tax %tARR of U perccnc. Sherri feels that some good projcc havc been missed becausc che cffcccs of taxation on che projects have not bccn examined in enough detail, so shc proposed reviewing the projects on an after-tax basis. 'Iut would l)e a good choice 01 after-tax MARR for her rcview SGAI pays 45 percent corporate taxes. PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CNAPTC 7 laxes ?41 Akiinugli the iisue oÍe1ecüng n after-tax \1ARR is Iilet to h more cornplkated, recorub1e choice for Sherri would be to uce Equation (7.1) s wy of caIcu1crng an after-tax MARR for her review. lins gwec MAR R.kILcru = 0.12 X (I - 0.45) = Q.06 = 6.6% A reasonable choice for after-tax ÏtIARR would he 6.6 percera. \lRR biOW when to use the aftcr-tix ind when to use a beforetax MARR. In geTler.al, f yOU are d()it an aproxitnate calculation without taking taxes fltI) account exptictly, then you shouiI use a before-tax ALARR. Thus, aU tile examples in this book up co this point were appropriately done usiig a belore-tax MARR, boosted to account for the fact that profits would be taxed. I Iowever when con skiering taxes explicitly im calculations, the after-tax MARR should be used. There is no need to increase the deci5ion thrcshold when the proììts that arc lost ro taxes arc dreaJy taken lt is import;ult CO into account. 1.5 The Effect of Taxation on Cash Flows There is a cet of sh flows chat arises whenever an iiwescment is made. Consider the following example. Ebcon Corp. is considering purdiasing a small LICVICC Used to test printed circuit boards that has a first cost of $4 DoD. The tester is expected co reduce labour costs and improve the defect detection rate so as to bring about savings of $23 0(X) per year. Additional operating costs arc cxpectcd to lic $73(X per year. The salvage value of the tester wiH be $5000 in Ave years. lhe corporate tax rate is = 42 percent and th aftertax AlRR is I 2 pertcnt. lucre are thrc . . e U key cash how cicments in this example. First cost: chc $45 000 investment. This is a negative cash flow made at unie zero. Net annual savmgs: the S23 00() per year savings less the $7300 additional operating costs for a net$15 700 positive cash flow at the end ofeach ofyears one w five. Salvage value: the $5000 residual value oldie tester at the end of its service life in five years. Fach of thcsc cash flow elements is affected by taxcs and in different ways. En this section we will explore the influence of coqx,ratc ncs on the tsh flows for verr diìs inveslinent untier sirn1,1i1ed tax rules that are ilot common in Canada. 1he actual rules of clic Canadian tax c'stern are quite complicated. probably the most complicated n the world arid are better dealt wali after the basic prirxcip1 have been established. 1.5.1 The Effect of Taxes ori First Cost Companies are taxed on net profits. which are revenues less expenses. Consequeral) when an expense is incurred, less tax is pad. From this perspective, although the tester in PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor 244 CHAPTIII ? Tucet Fxmpk hJ cost of $45 OOO ¡f thic Arst cost couid be rcccgni7cd as n icnrnedift t:xi)ui, ikert would 1c a t;ix aving ufS45 000 x 0.42 - $18 900. }liwever the itx henefic. ;we usu.iIk Cliuiult(1 ;u Lue eiiti uÍ tx yeir. .kcsurnìnR that the tecter wt purched at the beginning uf the year, and the tax saviìg accrue at the end of thn (N)() + samc year, thcn thc prcscnt worth ol the lirsi coc of thc tester wuId QnIy be $18 900(P/F12%,1) = $45 000 + SIS 900(0.89286) $28 000. Ilowrver, by tax nues, capital purchases such as production equipment cannot U5Ually be FuIt c6irned ai an expence iii hie year in which Lite purcIie occurred. The logic is tased on the idea ofdepreciauon. Acec retain value over unie. Their loss in va1ue ac oppoced to their coc. trht tax ruTes generally reconize as an eligible expense. Given a choice, a finii would want to write off (i.e., depreciate) n investment is quickly as paissibic. Sncc deprcc:ation is considered an cpcnsc and offsets revenue the earlier the epemsr is recogni7cd. thc earher the ta savings wilT accrue. Sinoe money earlier in LiTTle worth more iIuui the iarne arnourn oImoney later in time, there Lc good reason tu deprecvate cptal assets as quwkly as a1luwhIe. This effect of reductiig taxec can be coiiciderable. Although companies would of course, like to rcducc taxes by writing off their aecc as quickly as possibIe. there arc also undesirable cfÑ,cts of doing this. For one thing, it tnay lead to accounting dcwurnentc that are riot represcuiLicive of a 1km actual financial 5it-uat:i()fl. F'or if valuable c1,ital acsets are aigned-for tax reacons-tc) have ni excessively low b,ok value, tl'us may underrepresent the true value of che compaiìy ac an a whole. It may also creatc an opporninicy for inefficient business dccision-s. From thc perspective of thc government imposing the taxes, it can lead to companies improperly ecpIoiting the tix rules. To couuter these undesirable effects, tax utlioritie have carefully tielined tue derecìaiion tnethods the Permit for wie iii coinuiing taxes. The ennkted inediods for claiming depreciation expenses may not reiiec the true deprecinioii of an ascet, they are rulc-oriented rather than truly attempting to recognize thc diminishment iii value of an assec. Conscqucntly, chc dcprcciation charge is rcfcrrcd to by a difkrcnt name-the ipit4 c aioz'ai:tr-to recognize that the book value implied by the taxaiicrn-related depreciation charges does not riececsari1 reprecent a good eciimate of the asset market value. however, there is usually a fair correspondence between capital cost allowance auJ depreciation, and many firms do not distingu1sh henveen them in caic-ulations for their financial ctatcmen. Lt is chcrcforc reaconablc to thmk of theni as being the same thing for most purposes. 7.2(A) a Irst 45 ljx ruTes for Fbcon Corp. (see Example 7!(A)) speci that the capital allowance For thc ieLtt he calculited as straight-line dcrecation over die life uf the tester. ''ha is the pre,ent worth oldie testers first cost? This seems like an odd qucstion but it rcuks from the 1ct that in a taxed company; iRe first cost irnrnetliaely rise to future tax savings. This exanipte is criterit wiili one of the depreciation methodologies occasionally permitted as au investment mcencive Canada As i1tutratetI in Figure 7.1, the first cost of$45 (J0() gives rise to h.eiiefii in the form of an annuity of 45 000 x 0.42/5 $3780. In a sense, the presence of taxes transforms the $45 ()00 purchasc into a more complcx s'ct of cash flows consisting of not only che first cost but also a subscanúal annuity. Lfl PDF compression, OCR, web optimization using a watermarked evaluation copy of CVISION PDFCompressor CIUPTC Figure 7.1 The Beneficial Effects of a First Cost (for Example 760 tax 5axlngs per 7 laxes ?45 72) wii hie present worth of the fIrst yost is then: PW - -45 000 + 37H0(P/AJ2%,5) = -45 001) + 3781)(3.bO+8) The present worth of the zecter lìr cos is ibouc -$3 I 400. -31 400 Note that this result is rnore coct1 for Fbcon by aLmut $3 400 - $2 000 = $3400 il Ehcou could the eu1tre Lester in the ear of purctiae. This difference s increased the preseni worth uf the Uxes that the government tecCivCs uy not .dhwing Fbcon co count che tester as an expense m the year that it .traç purchased. ¡he Effect 1.5.2 I exne lilark of Taxes on Savinas .'ilthough iii a taxed business environment the first cost is reduced, this is balanced by the fact that the savings from the investinent are also reduced. An uiiilerivirig assurnplion is iliac any inve-_Stukent decision Ls made in a pnfitah1e company for which ibis ttecision is a relatively siuill part of the overall husuiess. Consequently, if any rnoiìey is savcd those savings increase thc profits of che finii. And since profits arc taxed at the tax rate, the net savings arc reduced proportionah1} present worth of the annual ncc savings created by the tester? hlie approach used i to reduce the net annual savings ci the teste...
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