Engineering Economic Analysis

After-Tax Cash Flows and Spreadsheets

Depending on the specific investment tax credit provisions, the credit might be subtracted

,from the basis for depreciation, or the basis for computing depreciation might remain the

full cost of the equipment. The Tax Reform Act of 1986 eliminated the investment tax

credit. It is likely, however, that it will reappear at some future time.

ESTIMATING THEAFTER-TAX RATE OF RETURN

There is no shortcut method for computing the after-tax rate of return from the before-tax

rate of return. One possible exception to this statement is in the situation of nondepreciable

assets. In this special case, we have

After-tax rate of return=(1 - Incremental tax rate) x (Before-tax rate of return)

For Example 12-6, we could estimate the after-tax rate of return from the before-tax rate of

return as follows:

After-tax rate ofreturn =(1- 0.39)(8.5%)=5.2%

This value agrees with the value computed in Example 12-6(b).

This relationship may be helpful for selecting a trial after-tax rate of return when the

before-tax rate of return is known. It must be emphasized, however, this relationship 'is only

a rough approximation in almost all situations.

AFTER-TAXCASH FLOWS AND SPREADSHEETS

The starting point for after-tax analysis is to calculate before-tax cash flows (BTCF) and

taxable income. Before-tax cash flows may include first costs and principal payments on

loans, which are not tax deductible. Taxable income deducts depreciation-which is not a

cash flow. Once these principles are understood, spreadsheetscan help with the arithmetic.

Taxes are computed based on taxable income, and after-tax cash flows are computed by

subtracting taxes from BTCF.

Realistic after-tax analysis requires spreadsheets. Even if costs and revenues are the

same every year, MACRS depreciation percentages are not. The steps for calculating 'an

after-tax internal rate of return are illustrated in Example 12-7.Because some cash flowsare

taxed and some are not, the spreadsheet is easier to build if these two classes are separated.

Spreadsheet construction is easier, as well, if recaptured depreciation or other gainlloss on

disposal or sale is tabulated separately.

Taxes are considered even if only the costs of a project are known. The firm that d~es

an engineering project must generate profits-or go out of business. Even if a firm has an

unprofitable year, the tax law includes carry forward and backward provisions to transfer

deductions to profitable years. The depreciation and revenues in Example 12-7 result in a

negative taxable income for Year 2. Thus thepositive cashflowdue to taxes that is shown

in Year 2 of Example 12-7 really represents tax savings for the firm.