Tax Income, Sunk Cost and Opportunity Cost

Week 13

A. The key point is that since taxes are a cash outflow of a project, our economic analyses must reflect the after-tax cash flow of a project in order to achieve a true reflection of the cash flow patterns.

B. Tax laws are imposed for revenue generation. However, a secondary purpose is that of social legislation. The laws are very complex with many exceptions. However, this section attempts to capture the fundamental concepts.

C. In a sense, the government shares in every profitable venture through the taxation of a portion of the profits. The contra is also true if the individual or corporation has other profit generating activities to offset the loss in a venture.

D. Forms of business organization for tax purposes: Individual: Applicable to an employee, a sole proprietor (individual engaging in business alone) or individual members of partnerships; taxed at individual rates. Partnership: Must file annual information return, each partner is taxed on his share of partnership earnings whether or not distributed. Corporation: Taxed at corporate tax rates unless the corporation qualifies for Subchapter S treatment (25 or fewer stockholders) in which case the Subchapter S is treated like a partnership.

Thus we note that earnings to a corporation are taxed twice: Once while in the corporation Once after distribution to shareholders as dividends This occurs because dividends are not a tax deductible expense for the corporation.

E. Taxation for individuals: Marginal percentage rates increase as taxable income increases. Taxable income = adjusted gross income (revenue, earnings) - deductions for exemptions - itemized deductions in excess of standard deduction

F. Taxation for corporations: Tax rates: 35% currently Lower rates for taxable income below $10,000,000 Taxable income = gross income (revenue) - expenditures for operating expenses - tax depreciation and depletion Or if starting from net income of a company:

Taxable income = + + -

net income book provision for federal income taxes book depreciation tax depreciation

A key point to remember is that capital expenditures (buildings, machinery, etc.) are not deductible as operating expenses, but rather are recovered through depreciation or depletion. A second key point to note is that depreciation when considered as a tax deduction results in less taxes and therefore is a source of cash flow to match the cash outflow when the investment is made.

Example of computation of taxable income and computation of income tax for a corporation:

Gross Income (or revenue) Less : Salaries Operating Costs Raw Materials Tax Depreciation
Taxable Income Taxes Payable @ 35%

$3,000,000 180,000 200,000 1,500,000 620,000

$ 500,000 $ 175,000

G. As a practical matter, we normally assume a corporate tax rate of 35% ignoring the smaller rates at lower levels of taxable income. We do this because usually the firm for which the analysis is being done is large enough to have many projects and since the lower rates may be used on only once, the marginal rate for most corporations is 35%.

H. As a general rule, state income taxes are deductible from federal income taxes but not vice-versa. Texas has no state income tax.

Thus we can develop the following general rule:

State income taxes = State rate x taxable income

Federal income taxes = Federal rate (35%) x [Taxable income - State taxes]

Combining

= (State rate + Federal rate)(Taxable income) - Federal rate (State income taxes)

In the above taxable income is the same as taxable income before income taxes.

I. Capital gains and losses: If the selling price of a capital asset exceeds the book value, the excess of selling price over book value is called a capital gain. If the selling price is less than book value, the difference is a capital loss. For a corporation, capital gains are taxed at ordinary corporate tax rates. Corporate capital losses can be subtracted from any capital gains during the tax year. The net remaining losses may be carried back or forward. In general, capital losses cannot be used to offset ordinary operating income.

Key Accounting Concepts Financial Accounting (Or Book)

Net Income - earnings after recognition of revenues less operating expenses, book depreciation, and the book tax provision. Revenues - value of product sales or services rendered. Operating Expenses - salaries, product materials, rent, etc. Capital expenditures and dividends are not operating expenses. Book Depreciation - systematic allocation of original cost over the useful life of the asset. Book Tax Provision - tax rate times income before taxes.

Relationships
= =

Revenues Operating Expenses Depreciation (Book) Income Before Taxes Book Tax Provision Net Income

Key Comment: Net income does not equate to cash flow from operations as discussed later.

Tax Accounting
Net Income - no such term in tax accounting. Revenues - generally similar to book revenues. We assume no difference. Operating Expenses - generally similar to book definition. We assume no difference. Book Depreciation - no such term in tax accounting. Tax Depreciation - MACRS allocation of tax basis. Tax Basis - historical cost of asset less any accumulated tax depreciation. Taxable Income - revenues less operating expenses less tax depreciation. Current Taxes Payable - taxable income times tax rate.

Relationships
= x =

Revenues Operating Expenses Tax Depreciation Taxable Income Tax Rate Current Taxes Payable

The Concept of Deferred Taxes

Deferred income taxes is a concept associated only with the book or financial accounting. It is not a tax accounting concept. Tax accounting computes an income tax payable. It is payable for and within the current year. Book accounting also computes a provision for income taxes as a reduction of net income. Thus, the book provision for income taxes is based upon book depreciation and will differ from current taxes payable if book and tax depreciation are not equal. The difference between current taxes payable and the book tax provision is known as deferred taxes and thus is important in tracking cash.

Revenues Operating Expenses Depreciation Taxable Income Income Before Taxes Current Taxes Payable (46%) Book Provision (46%) Net Income

Tax $10,000 2,000 8,000 4,000 4,000 $ 1,840

Book $10,000 2,000 8,000 2,000 6,000 2,760 $ 3,240

NOTE:

Tax rate including state of 46% assumed.

Thus, our book provision for income taxes is $2,760 while our current taxes are $1,840. The difference of $920 is known as a deferred tax. The meaning of a deferred tax is that it represents a tax on current book year earnings that will be paid in a future year. The deferred tax could alternatively be computed as the difference in tax and book depreciation (4,000-2,000) times the tax rate (46%).

Assume the following depreciation schedules for book and tax purposes for a $10,000 asset:
Year 1 2 3 4 5 6 7 8 9 10 Tax Depreciation 800 1,400 1,200 1,000 1,000 1,000 900 900 900 900 10,000 Book Depreciation 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 10,000 Difference (200) 400 200 (100) (100) (100) (100) -0Tax Rate 46% 46% 46% 46% 46% 46% 46% 46% 46% 46% Deferred Tax (92) 184 92 (46) (46) (46) (46) -0Accumulated Deferred Tax (92) 92 184 184 184 184 138 92 46 -0-

Key Points
1. The deferred tax in the first year is negative meaning that the current taxes payable to the government are higher than the book income tax provision. 2. Over time the exact same amount will be taken for tax depreciation as taken for book depreciation. 3. Since the statement in 2. is correct, it follows that over time the accumulated deferred tax will become zero.

Some points to remember in calculating cash flows

Focus on incremental cash flowsthe difference in cash flows because of this project Forget sunk costs costs that have accrued in the past

Some points to remember in calculating cash flows

Include opportunity costs costs of highest potential benefits forgone by taking this project Consider incidental effects(also called side effects, externality)

Positive side effects benefits to other projects Negative side effects costs to other projects

Sounds abstract, but you all have applied these rules.

Relevant (incremental) Cash Flows

The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are also called incremental cash flows We analyze each project in isolation from the firm simply by focusing on incremental cash flows

Asking the Right Question

You

should always ask yourself Will this cash flow occur ONLY if we accept the project?

If the answer is yes, it should be included in the analysis because it is incremental If the answer is no, it should not be included in the analysis because it will occur anyway If the answer is part of it, then we should include the part that occurs because of the project

Sunk costs

The sunk cost is past cost and irreversible. Since it cannot be affected by the decision to accept or reject the project, it should be ignored. Is your education cost so far at SFSU sunk cost?

You plan to produce ice cream using some facility that you bought at $50,000 last year.

Should this $50,000 cost from the previous year be included in the analysis? No, this cost is a sunk cost and should not be considered.

Opportunity cost

The highest benefit forgone when you take a project The opportunity cost may be relevant to the investment decision even when no cash changes hands. Give me an example about the opportunity cost of studying at SFSU?

You plan to use the facility to produce ice creams. The facility could be leased out for $25,000 per year, would this affect the analysis?

Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25,000, which is an opportunity cost to be charged to the project. The relevant cash flow is the annual after-tax opportunity cost.

A-T opportunity cost = $25,000 (1 T) = $25,000(0.6) = $15,000

Opportunity cost is relevant.

Incidental Effects (Externality)

The side effects of taking a project. Give me an example of incidental effect if you got a degree from SFSU.

If the ice cream production were to decrease the sales of the firms other lines (for example, Yogurt), would this affect the analysis?

Yes. The effect on other projects CFs is an externality. Decreased CF per year on other lines would be a cost to this project. Externalities can be positive (in the case of complements) or negative (substitutes). Externality (also called incidental effect) is relevant.

Evaluating NPV Estimates

The NPV estimates are just that estimates A positive NPV is a good start now we need to take a closer look Forecasting risk how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk.

(Skip)

3 types of project risk (Stand-alone risk, Corporate risk, Market risk) Sensitivity analysis Scenario analysis Monte Carlo analysis

Real Option

Exercise Questions
A cost that has already been paid, or the liability to pay has already been incurred, is a(n): a. Salvage value expense. b. Net working capital expense. c. Sunk cost. d. Opportunity cost.

You bought some real estate 6 years ago for $25,000, and you are thinking of using this land for the construction of a new warehouse as part of a production expansion project.

You include the $25,000 purchase cost of the land as an initial cost in the capital budgeting process. By doing so, you are making the mistake of in the decision-making process. a. b. c. d. e. including erosion costs including opportunity costs including sunk costs including net working capital changes including financing costs

You bought some real estate 6 years ago for $25,000, and you are thinking of using this land for the construction of a new warehouse as part of a production expansion project.

You do NOT consider the $25,000 purchase cost of the land as an initial cost in the capital budgeting process. You also ignore the fact that the land now can be sold at $28,000. By doing so, you are making the mistake of ______in the decision-making process.

a. b. c. d. e.

excluding erosion costs excluding opportunity costs excluding sunk costs including opportunity costs including sunk costs

You bought some real estate 6 years ago for $25,000, and you are thinking of using this land for the construction of a new warehouse as part of a production expansion project.

You correctly do NOT consider the $25,000 purchase cost of the land as an initial cost in the capital budgeting process. You also correctly consider the fact that the land now can be sold at $30,000. But you forget to consider the fact that the new warehouse will attract more customer in the region and your other business (retailing, for example) will be positively affected. By doing so, you are making the mistake of ____in the decisionmaking process.

a. b. c. d. e.

excluding erosion costs excluding opportunity costs excluding sunk costs excluding incidental effects excluding financing costs

If two projects are independent, then:

a. Accepting one automatically implies rejection of the other. b. If one is undertaken, the other must be undertaken as well. c. Both will be undertaken, assuming each has a positive NPV and the firms capital budget can afford to include both projects. d. All of the above

Incremental cash flows refer to:

a. The difference between after-tax cash flows and before-tax accounting profits. b. The additional cash flows that will be generated if a project is undertaken. c. The cash flows of a project, minus financing costs. d. The cash flows that are foregone if a firm does not undertake a project.

Which of the following should be included in an analysis of a new project? a. Any sales from existing products that would be lost if customers were expected to purchase a new product instead. b. All financing costs. c. All sunk costs. d. All of the above. e. None of the above.

Adams Audio is considering whether to make an investment in a new type of technology.

Which of the following factors should the company consider when it decides whether to undertake the investment? a. The company has already spent $3 million researching the technology. b. The new technology will affect the cash flows produced by its other operations. c. If the investment is not made, then the company will be able to sell one of its laboratories for $2 million. d. Statements b and c should be considered. e. All of the statements above should be considered.

Kasus:

Sebuah perusahaan travel Glory ingin mengembangkan bisnisnya, mereka ingin membuka usaha baru yaitu taxi. Perusahaan ini ingin mencoba usaha barunya ini di kota Bandung. Di bandung mereka memiliki 3 pool (travel) yang akan mereka jadikan pangkalan taxi baru.

Kasus Lanjutan

Pada suatu rapat pimpinan, Niki diminta untuk mempelajari kelayakan perusahaan ini mengoperasikan armada taxi baru. Studi yang dilakukan Niki menghasilkan kesimpulan bahwa ide mengoperasikan armada taxi sendiri ini layak diterima. Masalah berikutnya adalah sebaiknya Glory Travel membeli atau me-lease mobil Taxi tersebut. Menurut studi yang telah dilakukan diperoleh perkiraan bahwa dibutuhkan 15 unit taxi di tiap pol. Niki sudah meminta beberapa pemasok mobil untuk mengajukan penawaran. Yang terbaik adalah penawaran dari Bintang Baru Motor (BBM), sebuah agen penjual mobil di Bandung. BBM sanggup memasok mobil sesuai spesifikasi yang diminta dengan harga Rp. 5.175.000.000. Sudah termasuk pajak, biaya BPKB dan STNK. BBM meminta pembayarab tunai. Oleh karena itu Niki menghubingi Bank untuk menjajagi kemungkinan menggunakan kredit dan memperoleh jawaban sebagai berikut: Bank bisa memberi pinjaman sebesar 70% dari nilai asset yang akan dibeli (Glory membayar 30% sendiri). BPKB mobil akan di tahan di Bank sebagai jaminan selama periode kredit. Pinjaman dengan jaminan ini memiliki jangka waktu 8 tahun. Bunga pinjaman ini adalah 20% dari saldo pinjaman. Selain itu akan ada biaya untuk proses dan perjanjian kredit sebesar Rp.2.000.000

Sedangkan dari perusahaan leasing diperoleh jawaban sebagai berikut: Perusahaan leasing dapat menyediakan mobil yang diminta dan melease ke Glory dengan biaya lease Rp. 2M per tahun, dibayar pada awal setiap tahun, untuk 10 tahun. Asuransi dan maintenance di tanggung perusahaan leasing. (Hal ini menarik sebab menurut perkiraan Niki biaya asuransi dan maintenance besarnya Rp. 7 juta setahun untuk setiap unit taxi). Perjanjian lease menyatakan: pada akhir masa lease, lesee harus membeli Taxi ini pada fair market value. Peraturan pajak mengharuskan perusahaan men-depresiasikan TaxiTaxi ini dengan metode DDB dengan masa depresiasi 5 tahun. Taxi jenis ini masa layannya panjang, sehingga pada akhir tahun ke 10 Taxi dapat dijual dengan harga Rp 40.000.000/mobil. Untuk menentukan pembiayaan yang terbaik, Niki ingat bahwa perusahaan terkena pajak penghasilan 30% dan mengharapkan return sebesar 18%. (untuk perhitungan tax shield depresiasi, dan pembayaran lease atau pinjaman). Bantulan Niki untuk membuat analisis untuk menentukan pembiayaan yang terbaik.

Jawaban