ENGR 301 – Engineering

Management Principles and

Economics
François Tardy
Credits: 3.5
Lecture 6
 Chapter 14
Taxes
ENGINEERING ECONOMICS

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 Outline
14.1 Introduction
14.2 Personal Income Taxes and Corporate Income Taxes
Compared
14.3 Corporate Tax Rates
14.4 Before- and After-Tax MARR
14.5 The Effect of Taxation on Cash Flows
14.5.1 The Effect of Taxes on First Cost
14.5.2 The Effect of Taxes on Savings
14.5.3 The Effect of Taxes on Salvage or Scrap Value
14.6 Present Worth and Annual Worth Tax Calculations

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 Outline
14.7 IRR Tax Calculations
14.7.1 Accurate IRR Tax Calculations
14.7.2 Approximate After-Tax Rate-of-Return Calculations
14.8 Specific Tax Rules in Canada
14.8.1 The Capital Cost Allowance System
14.8.2 Undepreciated Capital Cost and the Half-Year Rule
14.8.3 The Capital Tax Factor and Capital Salvage Factor
14.8.4 Components of a Complete Tax Calculation
• Note: CCA was covered as part of Depreciation

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 14.1 Introduction

• Taxes are fees paid by individuals or businesses to

support their government.
• Taxes can have a significant impact on the economic
viability of a project.
• If an investment yields a profit, profits will be taxed.
• This chapter begins with a general discussion and
concludes with specifics relating to the tax
environment in Canada how it can affect corporate
decisions.

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 14.2 Personal Income Taxes and
Corporate Income Taxes Compared
Personal Income taxes: Corporate Income taxes:
• Based on income less tax • Net income is based on
credits or deductions. gross income less
• Tax rates are progressive expenses
(i.e. the rate increases • Tax rates flat and depend
with income level…rates on the size of firm: 35%-
can vary between 25% 60%
and 50%) • The presence of capital
• No capital expenses expenses.

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 Personal Income Tax
• The textbook is concerned only with corporate taxes.
• However, Sole Proprietorships and Partnerships are subject to
personal income tax.

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 14.3 Corporate Tax Rates
This chapter is concerned only with corporate taxes, particularly
impact of income tax on viability of project
Table 14.1 compares corporate tax rates among several countries.

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 14.3 Corporate Tax Rates (cont.)
In Canada, small, Canadian-controlled private corporations often
have lower tax rates because of a Small Business Deduction,
resulting in an effective tax rate below 20%. Small business
deduction varies from province to province as well as from the
federal government.
http://turbotax.intuit.ca/tax-resources/sbt-small-business-deduction-qualify.jsp

http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/rts-eng.html

Provinces often give tax breaks to large companies if they are

willing to establish e.g. a factory in that province.
http://www.huffingtonpost.ca/2015/11/29/corporate-tax-cuts-canada-economy_n_8676646.html

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 14.4 Before- and After-Tax MARR
• So far, taxes have been “implicitly” incorporated into the
computations through use of “before-tax” MARR.
• Since taxes reduce profits, must set the appropriate “after-tax”
MARR for project acceptability.
If the impact of taxes is explicitly accounted for (i.e. by reducing
cash flows by tax rate), then the MARR used for the project must
be after-tax MARR.

MARRafter-tax ≈ MARRbefore-tax × (1 – t)
• This relationship given is a simplification.
• In practice, before- and after-tax MARR are often chosen
independently.

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 Example 14.2 (a)
14.5 The Effect of Taxation on Cash Flows
Ebcon Corp. is considering purchasing a small device used to test
printed circuit boards that has a first cost of $45 000. The tester is
expected to reduce labour costs and improve the defect detection rate
so as to bring about a saving of $23 000 per year. Additional operating
costs are $7300 per year. The salvage value of the tester will be $5000
in five years. Corporate tax rate is 42% and after-tax MARR is 12%.
There are three cash flow elements in this example:
• First cost: the $45 000 investment; negative cash flow at t0.
• Net annual savings: $23 000 savings less the $7300 in operating
costs for net positive cash flow at end of each of years 1–5.
• Salvage value: the $5000 residual value of tester at end of 5 years.
• Each of these cash flow elements is affected by taxes, and in
different ways.
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 14.5.1 The Effect of Taxes on First Cost
Companies are taxed on “net profits” (revenues – expenses).
• When an expense is incurred, less tax is paid.
• In example 14.2(A), the tester had a first cost of $45 000.
• By tax rules, capital purchases cannot be claimed as an
expense in the year in which they are purchased.
• It is the “loss in value”, as opposed to the cost, that the tax rules
recognize as an eligible expense.

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 14.5.1 The Effect of Taxes on First Cost
• Given a choice, a firm would want to write off (i.e., depreciate)
an investment as quickly as possible.
• But tax authorities have carefully defined depreciation methods
they permit to use in computing taxes.
• These permitted methods may or may not reflect the true
depreciation of an asset, as they are rule-oriented.

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 14.5.1 The Effect of Taxes on First Cost
The depreciation charge is referred to as capital cost allowance.
The book value implied by tax-related depreciation charges does
not necessarily represent an asset's market value.
So, in this book:
• Capital cost allowances = depreciation expenses
• Undepreciated capital cost = book value
Tax rules in Ebcon Corp’s country (see Example 14.2(A)) specify
that the capital allowance for the tester be calculated as straight-
line depreciation over the life of the tester. What is the present
worth of the tester’s first cost?
• Note that the country is not Canada, which uses CCA.

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 Example 14.2 (b)
• The first cost of $45 000 gives rise to tax benefits in the form of
annuity of $40 000 x 0.42/5 = $3360 (note: DSL=(P-S)/N)
• PWfirst cost = – 45 000 + 3360(P/A, 12%, 5) = – $32 888
• Note: costlier result than – $28 000 = 0.42(– $45 000) if Ebcon
could expense tester in the year of purchase.

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 Example 14.2 (c)

• What is PW of annual net savings created by the tester?

• Reduce the net annual savings by the tax rate, as below and
then bring the amount to a present worth:
PWsavings = (23 000 – 7300) x (1 – 0.42) x (P/A, 12%, 5) = $32 825

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 Example 14.2 (c)

What is PW of salvage value of the tester?

Reduce the salvage value by the tax rate, as below and then bring
the amount to a present worth:
PWsalvage = 5000 x (1 – 0.42) x (P/F, 12%, 5) = $1646

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 14.6 Present Worth and Annual Worth
Tax Calculations
• So, a complete tax calculation consists of recognizing how taxes
affects each component of an investment.
• The table below summarizes the procedure for PW comparison.

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 Example 14.2 (e)

What is the PW of the components of investment?

PWfirst cost = −45 000 + 3360(P/A, 12%, 5) = – $32 888
PWsavings = (23 000 – 7300)(1 – 0.42)(P/A, 12%, 5) = $32 825
PWsalvage value = 5000 x (1 – 0.42) x (P/F, 12%, 5) = $1646
PWtotal = −32 888 + 32 825 + 1646 = $1583

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 14.7 IRR Tax Calculations
14.7.1 Accurate IRR Tax Calculations
• What is accurate after-tax IRR of tester investment?
• Set sum of PW of receipts equal to PW of disbursements and solve
for the unknown i*:
45 000 = (40 000/5) (0.42)(P/A, i*, 5) + 15 700 x (1 – 0.42)(P/A, i*, 5) +
5000(1 – 0.42)(P/F, i*, 5)
By trial and error: i* = IRRafter-tax =
13.4%
With an after-tax MARR of 12%, the
project is acceptable.
 14.7.2 Approximate After-Tax Rate-of-
Return Calculations
• An analysis using an “approximate” IRR approach when taxes
are involved is much easier.
• Use approximation: IRRafter-tax ≈ IRRbefore-tax x (1 – t)
• First find the before-tax IRR:
• 45 000 = 15 700(P/A, i*, 5) + 5000(P/F, i*, 5)
• By trial and error: the before-tax IRR = 23.8%
• IRRafter-tax = IRRbefore-tax(1 – t) = 0.238(1 – 0.42) = 0.13804
• The approximate IRR of 13.8% is a bit higher than the accurate
IRR of 13.4%.
• If the after-tax MARR were 14% rather than 12%, it would give
rise to an incorrect investment decision.
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 14.8 Specific Tax Rules in Canada
• The textbook tax calculations in Examples 14.2(A)-(G) were
subject to straight-line depreciation over life.
• In Canada, most assets must be depreciated using a more
complex declining-balance based method.
• The depreciation rate depends on the type of asset
• Regulations are set out in the in the capital cost allowance
(CCA) system.
• Note that CCA was already presented as part of the
Depreciation chapter.

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 14.8.1 The Capital Cost Allowance System

Companies and individuals may deduct capital expense over

period of years by claiming depreciation expense each year of the
useful life.
The depreciation is recorded in two ways:
1. it is recorded in balance sheet as a reduction in the book value.
2. it is recorded as a depreciation expense on the income
statement thereby reducing the before-tax income.
• Because depreciation is considered an expense that offsets
revenue, best to “write off” ASAP.
• However, Canadian tax system defines a specific amount of
depreciation called the capital cost allowance (CCA).
• There are “classes” that dictate CCA rates.
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 14.8.1 Capital Cost Allowance System
The depreciation rate is called Capital Cost Allowance (CCA).
The class of asset dictates the actual CCA rate.
• i.e. buildings are depreciated more slowly than vehicles
Typically, engineering projects fall into class 8, with a 20%
declining balance depreciation rate.
The remaining value in each pooled account is called the
Undepreciated Capital Cost (UCC).

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 14.8.2 Undepreciated Capital Cost
Allowance and the Half-Year Rule
• Capital cost of asset is total acquisition cost (incl. Installation,
transportation, legal, accounting, etc.).
• As asset is depreciated, company keeps track of UCC which
may differ from market or salvage value.
• The Canadian tax system uses the half-year rule in the year of
purchase and salvage only half the usual depreciation is
applied. See Table on next page.
𝑈𝐶𝐶𝑜𝑝𝑒𝑛𝑖𝑛𝑔 + 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑠 + 𝑑𝑖𝑠𝑝𝑜𝑠𝑎𝑙𝑠 − 𝐶𝐶𝐴 = 𝑈𝐶𝐶𝑒𝑛𝑑𝑖𝑛𝑔

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 14.8.2 UCC and the Half-Year Rule
Table 8.7 Summary: The Half-Year Rule
Component Treatment
Purchase Add only half of the purchase cost of an asset to the
base UCC amount for its CCA class in the year of
purchase. After the CCA calculation, add the other
half to the remaining UCC (note that the second half
is not considered an acquisition in the following year)

Disposition Subtract the full amount received for the disposition

of an asset from the base UCC amount for its CCA
class.
Purchases and Subtract total dispositions from total purchases for
dispositions in each CCA class
class, same If the remainder is positive, treat as a purchase.
year If the remainder is negative, treat as a disposition.
 14.8.3 The Capital Tax Factor and
Capital Salvage Factor
Assume an asset purchased for $100 000; 20% CCA rate
• In the first year, a CCA claim of $10 000 (half-year rule)
• With a tax rate of 50%, saves $5000 in taxes
• Therefore the PW of $100 000 asset is less than $100k
• reduced by PW of tax savings of future years (See Table 14.9, Tax
Savings Due to the CCA (50% Tax Rate) in your textbook.)
𝑃𝑊𝑡𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
= $5000 𝑃Τ𝐹 , 𝑖, 1 + $9000 𝑃Τ𝐹 , 𝑖, 2 + $7200 𝑃Τ𝐹 , 𝑖, 3
+ $5760 𝑃Τ𝐹 , 𝑖, 4
So PWtax savings reduces the first cost of the investment!

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 Summary
• Income taxes can have a significant effect on engineering
economic decisions.
• The first cost of an asset is reduced because it generates a
series of expense claims against taxes in future years.
• Any beneficial savings brought about by the investment are also
taxed, and consequently the benefit is reduced.
• Generally speaking, the effect of taxes is to alter the cash flows
of a project in predictable ways, and the principles of PW, AW,
and IRR analysis are simply applied to the modified cash flows.

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