ENGINEERING ECONOMY

Instructor: Lai Van Tai

 Chapter 6
DEPRECIATION COSTS AND
THE CASH FLOW AFTER TAX ANALYSIS
 Chapter 4
CONTENTS
- Income statement - Profit after tax
- Depreciation – why?
- Depreciation method – The straight line method SL
- Tax and Cash flow after tax (CFAT)
- CFAT: Comparison and selection
 TAXES AND INCOME TAX RATE
o Taxes
n VAT,
n Individual income tax,
n Corporate income tax
n Asset tax…
o Corporate Income tax
INCOME STATEMENT
DEPRECIATION of PROPERTY
o Depreciation is the decrease in value of physical
properties with the passage of time and use.

o Depreciation is an accounting concept that

establishes an annual deduction against before-tax
income

o Depreciation is a noncash cost that affects income

taxes
 DEPRECIATION of PROPERTY
CHARATERISTIC: Property must be…
o used in business or held to produce income.

o have a determinable useful life (defined in Section

7.2.2), and the life must be longer than one year.
o something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
o not inventory, stock in trade, or investment property.
DEPRECIATION METHODS
o Straight-Line (SL),
o Declining-Balance (DB), Double DB
o Sum of the Years Digits (SYD)
o the Modified Accelerated Cost Recovery System
(MACRS)
o …
Straight-Line (SL) Method

D = (P – SV)/N
n N = depreciable life of the asset in years;
n P = cost basis, including allowable adjustments;
n D = annual depreciation deduction in year k(1 ≤ k ≤ N);

n BVk = book value at end of year k; BV = P – D*k

n SV = estimated salvage value at end of year N;
n dk∗ = cumulative depreciation through year k,
uirement, which includes the effect of income taxes, for studies involving on
The
CF can Before-Tax
be obtained from theand After-Tax
following Minimum
relationship:
Attractive
(Before-tax Rates
MARR)[(1 of Return
− Effective income(MARR)
tax rate)] ∼
= After-tax MARR.
us,
RECIATION AND INCOME TAXES After-tax MARR
Before-tax MARR ≈ . (7-1
(1 − Effective income tax rate)
requirement, which includes the effect of income taxes, for studies involving only
BTCF can
ermining thebeeffective
obtainedincome
from thetax
following
rate forrelationship:
a firm is discussed in Section 7.7.
This approximation is exact if the asset is nondepreciable and there are no ga
(Before-tax MARR)[(1 − Effective income tax rate)] ∼
= After-tax MARR.
osses on disposal, tax credits, or other types of deductions involved. Otherwi
se Thus,
factors affect the amount and timing of income tax payments, and some degr
rror is Before tax
ointroduced into MARR usuallyinlarger
the relationship than
Equation
After-tax after tax MARR
(7-12).
MARR
Before-tax MARR ≈ . (7-12
(1 − Effective income tax rate)
6.3Determining
The Interest Rate
the effective to tax
income Useratein
forAfter-Tax Studies
a firm is discussed in Section 7.7.
This approximation
y practical definition of is
a exact
MARR if the asset isserve
should nondepreciable
as a guideand for there are no gain
investment pol
or losses
attain on disposal,
the goals towardtax credits,
which or other
a firm is, ortypes
willofbe,deductions
striving. involved. Otherwise
One obvious goal
these
meet factors affect
shareholder the amount and
expectations. timing
Clearly, of incomegoals
long-term tax payments, and structure
and capital some degrew
of error is introduced into the relationship in Equation (7-12).
changing as a firm matures. In this regard, it is widely accepted that in after-t
Cash flow
Different by tax viewpoint
o Before tax cash flow (CFBT)

o After tax cash flow (CFAT)

Different by source of capital

o For 100% funded by owners of the firms

o For enterprises which use capital from borrowing

CFAT For non-debt firms
o CFBT = Revenue – costs
o Costs include production costs and operation costs
o Taxable income (TI) = CFBT – Depreciation costs
n income before tax
o Income tax = TI * tax rate

o CFAT = CFBT – Income Tax

CFAT For non-debt firms (Ex.)
Certain new machinery, when placed in service, is estimated to
cost $180,000. It is expected to reduce net annual operating
expenses by $36,000 per year for 10 years and to have a $30,000
SV at the end of the 10th year. Develop the CFBT and CFAT if the
tax rate is 6%. Calculate the after-tax PW when the after-tax
MARR = 10% per year.
D = (P-SV)/10 = (180000-30000)/10 = 15.000
CFAT For non-debt firms (Ex)
yea revenue cost CFBT Deprecia TI Tax CFAT
r tion
0 180000 -180000 -180000
1 36000 36000 15000 21000 1260 34740
2 36000 36000 15000 21000 1260 34740
3 36000 36000 15000 21000 1260 34740
4 36000 36000 15000 21000 1260 34740
5 36000 36000 15000 21000 1260 34740
6 36000 36000 15000 21000 1260 34740
7 36000 36000 15000 21000 1260 34740
8 36000 36000 15000 21000 1260 34740
9 36000 36000 15000 21000 1260 34740
10 36000 36000 15000 21000 1260 34740
10 30000 30000 0 30000
 CFAT indebted firms
For initial capital outflow = initial investment - borrowing
o CFBT = Revenue – costs
o Costs include production costs and operation costs
o Taxable income (TI) = CFBT – Depreciation – interest
payment
o Income tax = TI * tax rate

o CFAT = CFBT – Income Tax – interest & Principle payment

n Note: the Year paying debt, CFAT should deduct principle
payment
Schedule of payment
o Pay same interest annually the pay the principle by
the end
o Pay lump sum amount by the end
o Pay same amount annually include interest and
some amount of principles
Schedule of payment
o Borrowing 1000 USD for 5 year with rate of
10%/year. Pay same amount annually include
interest and principles
è A = 1000.(A/P, 10%, 5) = 1000*0.264 = 264 USD
Schedule of payment
Beginning of Annual interest principle paid Principle
the year payment remain ta year
end
1000 264 100 164 836
836 264 83.6 180.4 655.6
655.6 264 65.56 198.44 457.16
457.16 264 45.716 218.284 238.876
238.876 264 23.8876 240.1124 -1.2364
Example
A company considers to invest on a production line of
shampoo. It is known that the initial investment of this
machine is 15 thousands USD; the SV of machine after
5 years of using is 3 thousands USD. The revenue and
costs of this project are 7000 USD and 2000 USD,
respectively. If tax rate is 20% and price of machine
would be sold at rate of 4000 USD actually. Determine
1. CFAT if this project is 100% funded by the company
2. CFAT if the project is used 2000USD of borrowed
capital at 10%/year rate of interest. (supposed that
Interest would be paid annually and the principle
paid at year 5)
CFAT if this project is 100% funded by the company
yea revenue Expenses CFBT Deprecia TI Tax CFAT
r tion
0 15000 -15000 -15000
1 7000 2000 5000 2400 2600 520 4480
2 7000 2000 5000 2400 2600 520 4480
3 7000 2000 5000 2400 2600 520 4480
4 7000 2000 5000 2400 2600 520 4480
5 7000 2000 5000 2400 2600 520 4480
5 4000 3000 4000 1000 200 3800

12000/5
= 2400
CFAT if this project is 100% funded by the company
ye revenue cost CFBT Depreci bank TI Tax CFAT
ar ation
0 -15000 -15000 +2000 -13000
1 7000 2000 5000 2400 -200 2400 480 4320
2 7000 2000 5000 2400 -200 2400 480 4320
3 7000 2000 5000 2400 -200 2400 480 4320
4 7000 2000 5000 2400 -200 2400 480 4320
5 7000 2000 5000 2400 -200 2400 480 4320
5 4000 4000 3000 1000 200 3800
5 -2000 -2000
Example
A company considers to invest on a production line of
shampoo. It is known that the initial investment of this
machine is 15 thousands USD; the SV of machine after
5 years of using is 3 thousands USD. The revenue and
costs of this project are 7000 USD and 2000 USD,
respectively. If tax rate id 20% and price of machine
would be sold at rate of 4000 USD actually. Determine
1. CFAT if this project is 100% funded by the company
2. CFAT if the project is used 40% of borrowed capital
at 10%/year rate of interest. Pay the same annually
rate within 5 years including Interest and principal
CFAT if this project is 100% funded by the company
yea revenue Expenses CFBT Deprecia TI Tax CFAT
r tion
0 15000 -15000 -15000
1 7000 2000 5000 2400 2600 520 4480
2 7000 2000 5000 2400 2600 520 4480
3 7000 2000 5000 2400 2600 520 4480
4 7000 2000 5000 2400 2600 520 4480
5 7000 2000 5000 2400 2600 520 4480
5 4000 3000 4000 1000 200 3800

12000/5
= 2400
Schedule of payment
o Borrowing 6000 USD for 5 year with rate of
10%/year. Pay same amount annually include
interest and principles
è A = 6000.(A/P, 10%, 5) = 6000*0.264 = 1584 USD
Schedule of payment
Beginning of Annual interest principle paid Principle
the year payment remain ta year
end
6000 1584 600 984 5016
5016 1584 501.6 1082.4 3933.6
3933.6 1584 393.36 1190.64 2742.96
2742.96 1584 274.296 1309.704 1433.256
1433.256 1584 143.3256 1440.6744 -7.4184
 CFAT if this project is 100% funded by the company

depre
year revenue cots CFBT ciation bank interest TI Tax CFAT
0 -15000 -15000 6000 -9000
1 7000 2000 5000 2400 -1584 600 2000 400 3016
2 7000 2000 5000 2400 -1584 501.6 2098.4 419.68 2996.3
3 7000 2000 5000 2400 -1584 393.36 2206.6 441.33 2974.7
4 7000 2000 5000 2400 -1584 274.3 2325.7 465.14 2950.9
5 7000 2000 5000 2400 -1584 143.33 2456.7 491.33 2924.7
5 4000 4000 3000 1000 200 3800
Example
A company considers to invest on a production line of shampoo.
It is known that the initial investment of this machine is 15
thousands USD; the SV of machine after 5 years of using is 3
thousands USD. The revenue and costs of this project are 7000
USD and 2000 USD, respectively. If tax rate id 20% and price of
machine would be sold at rate of 4000 USD actually. Determine
1. CFAT if the project is used 40% of borrowed capital at
10%/year rate of interest. Pay the same annually rate within
4 years including Interest and principal
2. CFAT if the project is used 40% of borrowed capital at
10%/year rate of interest.(supposed that Interest would be
paid annually and the principle paid at year 4)
Schedule of payment
o Borrowing 6000 USD for 4 year with rate of
10%/year. Pay same amount annually include
interest and principles
è A = 6000.(A/P, 10%, 4) = 6000*0.3155 = 1893 USD
Schedule of payment
Beginning of Annual interest principle paid Principle
the year payment remain at year
end
6000 1893 600 1293 4707
4707 1893 470.7 1422.3 3284.7
3284.7 1893 328.47 1564.53 1720.17
1720.17 1893 172.017 1720.983 -0.813
 CFAT if this project is 100% funded by the company

depre
year revenue cots CFBT ciation bank interest TI Tax CFAT
0 -15000 -15000 6000 -9000

1 7000 2000 5000 2400 -1893 600 2000 400 2707

2 7000 2000 5000 2400 -1893 470.7 2129.3 425.86 2681.1

3 7000 2000 5000 2400 -1893 328.47 2271.5 454.31 2652.7

4 7000 2000 5000 2400 -1893 172.02 2428 485.6 2621.4

5 7000 2000 5000 2400 2600 520 4480

5 4000 4000 3000 1000 200 3800

 CFAT if this project is 100% funded by the company

depre
year revenue cots CFBT ciation bank interest TI Tax CFAT
0 15000 -15000 6000 -9000

1 7000 2000 5000 2400 -600 600 2000 400 4000

2 7000 2000 5000 2400 -600 600 2000 400 4000

3 7000 2000 5000 2400 -600 600 2000 400 4000

4 7000 2000 5000 2400 -600 600 2000 400 4000

4 0 -6000 0 0 -6000

5 7000 2000 5000 2400 2600 520 4480

5 4000 4000 3000 1000 200 3800