Chapter 11

Taxes

Ali Dehghan
Type of Taxes
 Income tax on revenues and profits

 Tax on assets and wealth

 Tax on sales

 Tax on value added to products and services

Tax and Economic
 Low tax rates encourage economic activity, higher
profits, and increased tax revenues for the
government.
Tax and ROI
 The organization’s ROI is very sensitive to tax rates.

 ROI is inversely proportional to the prevailing tax

rate.

 ROI After Tax = ROI Before Tax (1-t)

Example (Income Statement)

Without Depreciation With Depreciation

Sales $200,000 $200,000

Cost of Goods Sold $150,000 $150,000

Gross Profit $50,000 $50,000

Depreciation none $20,000

Profit Before Tax $50,000 $30,000

Tax @ 40% $20,000 $12,000

Profit After Tax $30,000 $18,000

Tax effects of depreciation
 A reduction in the amount of tax paid

 More cash available than only the income

Two main taxes
 Capital Gains Tax: Tax on the sale of assets and
investments

 Flat Tax: A tax that has a constant rate over all

taxable amounts, also called fixed percentage tax
rate

 Progressive Tax: A tax that has increasing rates so

that as the taxable amount increases, the tax rate
increases.
3 Categories of cash flow
 Operating: Funds are received from customers while
purchasing

 Investing: Funds may be disbursed the cash account

for investment in land, buildings, or equipments

 Financing: Funds may flow into the cash account by

borrowing money from a financial institutions or from
selling stock or bonds
Operating Cash Flow
 Operating Cash Flow = PAT + Depreciation
Or
 Operating Cash Flow = Gross Profit – Tax

 ROI Pretax = PBT / Investment

 ROI After Tax = (Annual Operating Cash Flow /

Investment)
 Example (P437)
 Saving per year= $12,000 , equipment cost= $60,000
 No Salvage Value after 6 years, Tax rate = 40%
 Example (P437)
 Try 10% : P=A(P/A, n=6,i=10%)= $12,000(4.3553)=$52,263
 Try 8% : P=A(P/A, n=6,i=8%)= $12,000(4.6229)=$55,474
 Try 6% : P=A(P/A, n=6,i=6%)= $12,000(4.9173)=$59,008
 Try 5% : P=A(P/A, n=6,i=5%)= $12,000(4.0757)=$60,908
 The pretax is between 5% and 6% (the exact answer is
5.47%)
 After Tax ROI:

Depreciation= (First Cost – Salvage)/Life= ($60,000-0)/6 years

= $10,000 per year
 Example (P437)
Annual Savings $12,000
Operating Cash Flow= Depreciation + Profit
Depreciation $10,000
After Tax = $10,000 +$1,200 = $11,2000/yr
Profit Before Tax $2,000
or
Increase in Tax @ 40% $800
Savings – Tax= $12,000 - $800 = $11,200/yr
Increase in profit After
$1,200
40%

Try 8% : P=A(P/A, n=6, i=8%)= $11,200(4.6229)=$51,776

Try 6% : P=A(P/A, n=6, i=6%)= $11,200(4.9173)=$55,074
Try 4% : P=A(P/A, n=6, i=4%)= $11,200(5.2421)=$58,711
Try 3% : P=A(P/A, n=6, i=3%)= $11,200(5.4172)=$60,673
 Example (P437)
 The after-tax ROI is between 3% and 4%. Exactly 3.34%
 A=P(A/P, n=6 yr, i=?) A/P=$11,200/$60,000=.1867
 ROI After Tax = ROI Before Tax (1-t) = 5.47%(.60)=3.28%
Minimizing Taxes
 Buying more expensive equipment leads to higher
depreciation that will cause higher costs, also causes
lower taxes
Net Operating Cash Flow
 Net income (net profit after tax and before dividends)
plus depreciation, amortization, depletion, write-offs,
and deferred taxes, less purchases of buildings,
equipment, and other fixed assets for the period.
Leverage
 Leverage is the purchase of buildings, equipment,
and other assets using borrowed funds

 If an investment has an ROI greater than the cost of

the borrowed capital, the funds should be borrowed
or obtained from the sale of securities