Blank L., Tarquin A. Engineering Economy (McGraw-Hill Series in Industrial Engineering and Management)
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SECT
ION 17.7
Af
ter-Tax Re
pl
acement Study
The proce
dur
e to
co
mpare a
lt
e
rn
a
ti
ves outlined
in
Se
ct
ion 8.6 is applie
d.
These are
r
eve
nu
e alterna
ti
ves, so
th
e overa
ll
i* values (ce
ll
s ]9 and I19) indic
at
e
th
at both CFAT
se
ri
es are accepta
bl
e. The va
lu
e
t::.i
* = 23.6% (ce
ll
J I 9)
al
so exceeds
MARR
=
1O
%, so
analyzer 2 is selecte
d.
This d
ec
ision applies the ROR method guideline:
Select
the a
lt
e
rn
a-
tive that requires
th
e largest, incrementally
ju
stified investment.
Comment
In
Sec
ti
on 8.4, Figure
8-
5b demonstrated
th
e fallacy of sel
ec
ting an alternative based
solely upon
th
e ROR.
Th
e
in
cremental ROR must be used. The same fa
ct
is demon
st
rated
in
this example.
If
the lar
ge
r i* alternative is chosen, analyzer I is
in
co
rr
ec
tl
y sel
ec
ted.
When
t::.i
* exceeds
th
e MA
RR
,
th
e larg
er
in
vestment is
conectl
y
cho
se
n
-ana
lyzer 2
in
this case. For ve
ri
fica
ti
on,
th
e PW at
10
% is
ca
lculated for
ea
ch analyzer (110 and l20).
Aga
in
, analyzer 2 is
th
e winner, based on its larger PW of $93,905.
17.7 AFTER-TAX REPLACEMENT STUDY
When a currently
in
sta
ll
ed asset (the defender) is challenged with possible re-
placement,
th
e effect of taxes can have an impact upon the decision of the
re
pl
acement stud
y.
The final decision may not be reversed by taxes, but the dif-
ference between before-tax A W va
lu
es may be significantly different from the
af
ter-tax
di
fference. There may be tax considera
ti
ons
in
the year
of
the possible
re
pl
acement due to depreciation recapture or capital gain,
or
th
ere may be tax
sav
in
gs due to a siza
bl
e capital loss, if
it
is necessary to trade the
def
ender at a
sac
rifi
ce pric
e.
Additionall
y,
th
e after-tax re
pl
acement study cons
id
ers tax-de-
ductible
de
pr
eciation and operating expenses not accounted for in a before-tax
ana
ly
si
s.
The
ef
fective tax rate Te is used to estimate the amount
of
annual taxes
(or tax sav
in
gs) from TI. The same procedure as the b
ef
or
e-tax replacement
study
in
Chapter II is applied here, but for CF
AT
estimates. The
pr
ocedure
sho
ul
d be thoroug
hl
y underst
oo
d b
ef
or
e proceedin
g.
Special attention to Sec-
tions
11
.3
and
11
.5
is recommended.
Example
17.1
2 presents a solution by hand
of
an after-tax replacement study
us
in
g a simplify
in
g assumption
of
classical
SL
(s
traight line) deprecia
ti
on. Ex-
ample
17.1
3 solves
th
e same problem by computer, but includes the deta
il
of
MACRS depreciation. This provides an opportunity to
ob
serve the differe
nc
e in
th
e AW values between
th
e two deprecia
ti
on assumptions.
EXAMPLE
17.12 "
Mid
cont
in
ent
Powe
r Autho
ri
ty purchased coal extraction equipment 3 years ago for
$600,000. Manageme
nt
has
di
scovered that it is t
ec
hn
ol
og
i
ca
ll
y outdated n
ow
. New equip-
ment has b
ee
n
id
ent
ifi
ed.
If
th
e market va
lu
e
of
$4
00
,
000
is offered as the b'ade-
in
for the
current equipment, perf
Olm
a repla
ce
ment study us
in
g (a) a before-t
ax
MARR
of 10% per
yea
r and (b) a 7% per year after-tax MARR. Assume an eff
ec
tive t
ax
rate of 34%. As a
simplify
in
g assumption, u
se
classical straight line depreciation with S = 0 for bo
th
alter-
natives.
595
Before-t
ax
replaceme
nt
596
CHAPTER 17 After-Tax Econo
mi
c Analysis
Defender
Chall
enger
Market value, $
400,000
First cost, $
1,000,000
Annual cost, $/year - 100,000
-
15
,000
Recovery pe
ri
od, years 8 (originally)
5
Solution
Assume that an ESL (economic se
rvi
ce life) analysis
ha
s determined
th
e best
li
fe va
lu
es to
be 5 more years for
th
e defender and 5 years total for
th
e challenge
r.
(a) For
th
e before-tax replacement study,
find
th
e
AW
va
lu
es. The defe
nd
er AW uses
th
e
market va
lu
e as
th
e
fir
st cost, Po = $- 400,000.
AWo = - 400,
000
(A/
P,IO%,5) - 100,000 = $- 205,520
AW
e = - 1,
000
,
000
(A/P,
IO
%
,5)
-
15
,000 = $- 278,800
Apply
in
g step I of
th
e re
pl
acement study procedure (Section 11.3), we sel
ec
t
th
e
better
AW
valu
e.
The defe
nd
er
is
reta
in
ed now with a plan to keep it
fo
r the 5 re-
maining year
s.
The defender h
as
a $73,280
lo
wer equivalent annual cost co
mp
ar
ed
to th
e cha
ll
enge
r.
This complete solution is included
in
Ta
bl
e
17
-6
(left) for com-
parison with
th
e after-tax study.
(b
) For
th
e a
ft
er-tax replacement study,
th
ere are no tax effects other than income t
ax
for
th
e defende
r.
The annual SL depreciation is $
75
,000, determined
wh
en
th
e
equipment was purchased 3 years ago.
D, = 600,000/ 8 = $75,000
t = I
to
8 years
Table
17
- 6 sho
ws
th
e TI and taxes at 34%. The taxes are actua
ll
y t
ax
sav
in
gs of
$59,500 per year,
as
indicated
by
the minus sign. (Remember that for t
ax
sav
in
gs
in
an
economic analysis
iti
s assumed there is positive taxable income else
wh
ere
in
th
e
corpora
ti
on to offset the saving.) Since only costs are estimated, the annual CFAT is
nega
ti
ve, but
th
e $5
9,
500 t
ax
savings h
as
reduced
it.
The CFAT and AW at 7% per
year are
CF
AT
= CFBT - taxes = - 100,000 -
(-
59,500) =
$-
40,500
AW
o = -
400
,
000
(A/P,7
%,
5) - 40,500 =
$-
13
8,056
For
th
e challenger, deprecia
ti
on recapture
on
th
e defender occurs
wh
en
it
is re-
placed, bec
au
se
th
e trade-in amount of $400,000 is larger than
th
e current book
va
lu
e. In year 0 for the cha
ll
enger, Table
17
-6
in
cl
ud
es
th
e fo
ll
ow
in
g computations
to a
rri
ve at a tax
of
$8500.
Defender book va
lu
e, year
3:
Depreciation recapture:
Taxes on
th
e trade-
in
, year 0:
BY
3
= 600,000 - 3(75,000) = $375,000
DR3 = TI = 400,000 - 375,000 = $25,000
Taxes = 0.34(25,000) = $8500
SECTION 17.7
After-Tax Re
pl
acement Study
TABLE
17-6
Before-Tax and After-Tax Re
pl
acement Analyses, Example 1
7.
12
Before Taxes
After
Taxes
Depre-
Taxable Taxes*
Defender
Expenses
dation
Income
at
Age
Year
E
Pand
5 CFBT 0
TI
O.34TI
DEFENDER
3
0
$- 400,000 $- 400,000
4
$-
100
,000 -
100
,000
$75
,000 $- 175,000
$-59,500
5 2
-
100
,000
-
100
,000
75
,000 -
175
,000 -
59
,500
6 3 -
100
,000
-
100
,000
75
,000 - 175,000 - 59,500
7 4 - 100,000 -
100
,000
75
,000
-
175
,000
-
59
,500
8 5
-
100
,000
0
- 100,000
75,000
-
175
,000
- 59,500
AW
at
10%
$- 205,520
AWat7%
CHALLENGER
0
$- 1,000,000 $- 1,000,000
$+25,000t
$
8,500
$- 15,000 -
15
,000
$200,000
-
215
,000
-73
,
100
2
-
15
,000 -
15
,000
200,000 - 215,000
-73,
100
3
- 15,000 - 15,000 200,000 - 215,000 - 73,100
4
-
15
,000 - 15,000
200,000 - 215,000 - 73,100
5
- 15,000
0
- 15,000
200,000
- 215,000'
-7
3,100
AWat
10
% $-
278
,800
AWat7
%
•
Minu
s
sign
indi
cate
s a
tax
s
aving
s
for
the
year.
t
Depreciation
recapture
on defender
trade-in.
j;
Assumes
c
hall
en
ge
r's s
alvage
actua
ll
y r
ea
li
zed
is
S =
0;
no
tax.
The SL depreciation
is
$1
,000,000/ 5 = $200,000 per year. This results
in
tax sav-
ing and CFAT as follows:
Taxes
= (-
15
,000 - 200,000)(0.34) = $- 73,100
CFAT
= CFBT - taxes = -
15
,000 -
(-73,100)
= $+ 58,100
In year 5, it
is
ass
um
ed the
cha
ll
enger
is
sold for $0; there
is
no depreciation recap-
ture. The
AW
for the cha
ll
enger at the 7% after-tax MARR is
AW
e = - 1,000,000(A/ P
,7
%,5) + 58,100 =
$-187,863
The defender
is
again selected; however, the equivalent annual advantage has de-
creased from $73,280 before
ta
xes to $49,807 after taxes.
Conclusion:
By
either analysis, retain the defender now and plan
to
keep it for
5 more years. Additionally, pl
an
to
eva
lu
ate the estimates for both alternatives
I year hence.
If
a
nd
when cash flow estimates change significantl
y,
perform another
replacement analysis.
597
CFAT
$- 400,000
-
40
,500
-40
,500
- 40,500
-40
,500
-40,5
00
$-
138
,056
$-
1,008
,500
+58,
100
+58,
100
+58,
100
+58,
100
+58,
100
$-187
,
863
598
CHAPTER
17
After-Tax Economic Analysis
Comment
lfth
e market value (trade-in) had been less than the cun'ent defender book value of$375,000,
a capital
lo
ss, rather than depreciation recapture, would occur in year O. The
re
su
lting tax
savin
gs
would decrease the
CFAT
(which is
to
reduce costs if CFAT
is
negative). For ex-
ample, a trade-in amount
of
$350,000 would r
es
ult
in
a
TI
of
$350,000 - 375,000 =
$-
25
,000 and a tax sav
in
gs
of
$-8500
in
year
O.
The CFAT
is
then
$-1,000,000
-
(- 8500) = $- 991,500.
EXAMPLE
17.13
;
Repeat the after-tax replacement study of the previous example (17.12b) using 7-year
MACRS depreciation for the defender and 5-year MACRS depreciation for the challenger.
Assume either asset is sold after the 5 years for exactly its book value. Determine if the an-
swers are significantly different from those obtained when the simpliJying assumption
of
classical SL depreciation was made.
Solution
Figure
17
- 8 shows the complete analysis. Refer to the cell tags for det
ai
ls
of
the comput
a-
tions. MACRS requires substantially more computation than SL depreciation, but this
effort is easi
ly
reduced
by
the use of a
sp
re
adsheet. Again the defender is selected
for
retention, but now by an advantage of$44,142 annually. This compares to the $49,807 ad-
van
tage using classical SL depreciation and the $73,280 before-t
ax
advantage
of
the
defender. Therefore, taxes
an
d MACRS have both reduced the defender's economic ad-
va
nt
age, but not enough
to
reverse the decisi
on
to
retain i
t.
Several other differences
in
the results between SL and MACRS depreciation are worth
noting. There is depreciation recapture
in
year 0
of
the challenger due
to
trade
in
of
the de-
fender at
$400,000, a value larger than
th
e book value
of
the 3-year-old defender. This
amount, $137,620
in
cell
GI8,
is
treated as ordinary taxable incom
e.
The calculations for
th
e DR and associated tax,
by
hand, are
as
follows:
BY
3 = first cost - MACRS depreciation for 3 years
= total MACRS depreciation for years 4 through 8
= $262,380
DR
=
TIo
= trade
in
- BV
3
= 400,000 - 262,380 = $137,620
Taxes
=
137
,620(0.34) = $46,790
(cell
Fll)
(cell G18)
(cell
HI
8)
See the ce
ll
tags for the spreadsheet relations
th
at duplicate this logic.
The assumption
th
at the challenger is sold after 5 years at its book
va
lu
e implies
a positive cash
flow
in
year
5.
The enu'y $57,600
in
cell C23
of
Figure 17-8 reflects
this
as
sumption, s
in
ce the foregone MACRS depreciation in year 6 would be
1,000,000(0.0576) = $57,600. The spreadsheet relation BJ5-F24 in cell C23 determines
SECTION
17
.8 After-Tax Va
lu
e-Added
An
alysis
}(
Microsoft EHcel - EHample 17
13
I!I~
t3
E F K M
Tdx
s.av
ings
C
FAT
-t
TI
3
4XofTI
D@fen
de
r a
ft
@r-t
aa
MACR
S ana
l,
s is
s
alv
a e va
lu
el
'l
(
E~;~
S;5
)
~
:
t
~~
S
r Oe r
(5
9.
~
80)
J
:
(400.oo0J
(174.9
40
J
(
4O.
520J
1'
~3.58
0J
_
(5
2.
217) $ (47.783)
o $ (400.00
0)
I $
(1
00
.
00
0)
0.1249
1'
-$
74,
940
(100.
00
0) 0.089} $ 53.
58
0
(100.000) 0.0892
$ 53.520 $ (153.5
20
) (
52
.197) $
(4
7.8
03J
(10
0.000) 0.0893 $ 5
3.
58
0 $ (
15
3.
580) (
52
.217) $
(4
7.783J
(126
.7
60) l 43.098) $ (56.902)
I = S U M
(F
6 :
FIO
) 1
pOO.OOO)
O.OH S $
26,760
$
$
2&2,380
A'I,/at
7X
$ (
14
5.273)
Cha
ll
en
ger
a
li
ef-tali
MA
CRS anal s is
= - $
C5
-$
F $
11
Fir
st cost & (Expenses) MACRS
Tax
s
av
in
gs
CFST rates 34%
ofTl
CFAT
137.620 $
is
.
79
1 $ (1.046
.7
91) 1
(215.000)
$ (
73.1
00) $
5
8:io
O
~
=
$C
I
9
+$
DI9
-
$H
I
9
1
20
21
22
23
24
4
5 $
(1
5.0
00)
(15.00
0)
(1
5.000)
(1
5.
00
0)
(15.000)
0.
32
00
32
0.
0
00
(335.0
00
) $ (
11
3.
90
0) $
98.9
00
. ! _
0.1
92
0 (
20
7
.0
0
0)
$
(7
0.380) $ 5
5.
380
0.1152 (130.20
Q)
$
(44
.268) $ 29
.2
68
0.
115
2
(1
30.200) $ (
44.
268) $ 86
.8
68
25
II'Chalien
ge
r assum
ed
to be
so
ld in
year
5 for
e~actly
A'oJ
at
7x
26 B
V.
1
.0
0
0.
000·94
2.
40
0 . $57.600.
27
No (.all
e-
ff
ect.
bu
t CF AT inc
re
ases in y
;;>a
r 5.
Sh
eet6 SheetZ
Fi
gu
re
17-8
After-tax replacement s
tu
dy using MACRS deprecia
ti
on
, Example
17.
13.
thi
s
va
lu
e us
in
g
th
e accumulated deprecia
ti
on in F24. [Note:
If
the amount S = 0 is de
fi-
nite
ly
anti.cipated after 5 year
s,
then a capital loss
of
$57
,6
00 would be incurre
d.
This
would imply an additional tax sav
in
g
of
57,600(0.34) = $19,584
in
year 5. Conversel
y,
if
th
e salvage va
lu
e exceeds the book
va
lu
e, a deprecia
ti
on recapture and associated tax
would be estimated.]
The ce
ll
tag indicates that
th
e CFAT estimates are developed using columns C, D,
an
d
H. For example, in cell
Jl
9, the CFAT is determined as C19 + D19 -
H1
9. Even though
columns C and D do not usua
ll
y bo
th
conta
in
entries, this general
fo
rm
fo
r C
FAT
calcula-
ti
on wo
rk
s correctly
wh
en the rela
ti
on is dragged down
th
ro
ugh column
1.
Therefore, the
CFAT computa
ti
on
in
ce
ll
1
23
correctly reflects the challenger sale
in
year 5 without alter-
ing
th
e spreadsheet formula.
17
.8 AFTER-TAX VALUE-ADDED ANALYSIS
Val
ue added is a term used to indicate that a product or service has added worth
from
th
e perspec
ti
ve
of
the o
wn
er, an invest
or
, or a consumer. It is possible to
hig
hl
y leverage
th
e value-added activities
of
a process. For example, o
ni
ons are
grown and sold at the
fa
rm level for cents per pound. They may be purchased by
&
599
600
CHAPTER
17
After-Tax Economic Analysis
the shopper in a store at 25 to
50
cents
per
pound.
But
when onions are cut and
coated with a special batter, they may be fried in hot oil and sold as onion rings
for dollars per pound. Thus, from the perspe
ct
ive
of
the
co
nsu
mer
, there has been
a large amount
of
va
lu
e added by the processing from raw onions in the ground
into onion rings sold at a restaurant
or
fast-food shop.
The
value added measure was briefly introduced in conjunction with AW
analysis before taxes. When value added analysis is performed after taxes, the
approach is
somew
hat different from that
of
CFAT analysis developed previously
in
this
cha
pte
r.
How
ever, as shown below,
The
decision
about
an
alternative will be the same for both the value
added
and
CFAT methods, because the
AW
of
economic value
added
esti-
mates
is
the same as the
AW
of
CFAT estimates.
Va
lue
added analysis starts with Equation [17.3], net profit
af
t
er
taxes (NPAT),
which includes the depreciation for year 1 through year
n.
T
hi
s is different from
CFAT, where the
depr
eciation has been specifically removed so that only actual
cash
fl
ow
estimates are used for year 0 through year
n.
The
term economic value added (EVA) indicates the monetary worth added by
an alternative to the corporation's bottom line.
Th
e technique discussed below
was first publicized in several
articles';'
in
the mid-1990s, and it has since b
ecome
very popular as a
me
ans to
eva
luate the ability
of
a corporation to increase its
economic
worth, especially from the shareholder
s'
viewpoint.
The
annual
EVA
is
the
amount
of
the NPAT remaining on
corporate
books
after
removing the cost
of
invested capital
during
the year.
That
is,
EVA
indicates
the
project's contribution to the
net
profit
of
the corpora-
tion
after
taxes.
Th
e cost
of
invested capital is the
af
ter-tax rate
of
return (usually the
MARR
value) multiplied by the book value
of
the asset during the year. This is the inter-
est
incurred by the current l
eve
l
of
capital
in
vested
in
the asse
t.
(If
different tax
and book depreciation methods
ar
e used, the book depreciation
va
lue is used
here, because it more closely represents the remaining capital invested
in
th
e
asset from the corporation's perspective.) Computationally,
EVA
= NPAT - cost
of
invested capital
= NPAT - (after-tax interest rate)(book value
in
year
t - 1)
=
TI(l
- Te) - (i)(BV
t
_
1
)
[17.18]
Since bo
th
TI
and the book value
co
nsid
er
depreciation, EVA is a measure
of
worth that mingles actual cash flow with noncash
fl
ows to determine the esti-
mated financial worth
co
ntribution to the corporation. This financial
wor
th
is
th
e
amount
used
in
public documents
of
the corporation (balance sheet,
in
come
statement, stock reports, etc.).
Because
corporations want to present the largest
*A. Blair. "EVA F
eve
r
,"
Manageme
l1l
Toda
y,
Jan. 1997,
pp.
42-45
;
W.
Freedman,
"H
ow
Do You Add Up?"
Che
mi
cal Week,
Oc
t.
9, 1996,
pp.
31
-3
4.
SECT
ION
17.
8
Af
ter-Tax Va
lu
e-Added Analysis
va
lu
e possible to the stockholders and other
owner
s,
the EVA method may
be
more appealing from the financial perspective than the AW method.
The
result
of
an EVA analysis is a series
of
annual EVA estimates. Two
or
more a
lt
erna
tives are compared by calculating the AW
of
EVA
est
imat
es and
selecting the alternative with the larger AW value.
If
only
one
project is evalu-
ated, A W > 0 means the after-tax
MARR
is exceeded, thus making the project
value addin
g.
Sullivan and Needy* have demonstrated that the AW
of
EVA and the AW
of
CFAT are identical
in
amount. Thu
s,
either method can be used to make a
decision.
The
annual EVA
est
imates indicate added worth to the corporation
generated by the alternative,
willIe the annual CFAT estimates describe
how
cash
will flow. This
co
mpa
ri
son is made
in
Example 17.14.
EXAMPLE
17.14
.
:"
Biotechnics Engineering has developed two mutually exclusive plans for investing in new
cap
it
al equipment with the expectation
of
increased revenue from its medical diagnostic
services to cancer patients.
The
estimates are summarized below. (
0)
Use classical straight
line depreci
at
ion, an after-tax MARR
of
12%, an effective tax rate
of
40%, and solution by
computer to perform two annual worth after-tax analyses: EVA and
CFAT.
(b) Explain the
fundamental difference betw
ee
n the results
of
the two analyses.
Plan A
Initial investment
$500,000
Gross income - expenses $170,000 per year
Estimated
li
fe 4 years
Salvage va
lu
e None
Solution by Computer
Plan B
$1,200,000
$600,000
in year I, decreasing
by
$50,0
00
per
year thereafter
4 years
None
(a) Refer to the spreadsheet and ce
ll
tags
in
Figure
17
- 9.
EVA
eva
lu
ation: All the nec
essa
ry
inf
ormation for EVA estimation is determined
in
columns B through G.
The
net profit after taxes (NPAT)
in
column H is calculated
by Equation
[17.3], TI - taxes.
The
book values (column
E)
are used to determine
the cost
of
invested capital
i.n
column I, us
in
g the second term
in
Equation [17.18],
that i
s,
i(B V,_
I)
' where i
is
the J 2% after-tax MARR. This represents the amount
of
interest at 12%
per
year, after taxes, for the currently invested capital as reflected by
the book va
lu
e at the beginni.ng
of
the year.
The
annual EVA estimate is the sum
of
columns H a
nd
I (Equation [17.18]) for years 1 through 4. Notice there
is
no EVA es-
timate
for
year
0,
since NPAT and the cost
of
invested capital are estimated for
years
I through n. Finally, the larger
AW
of
the EVA value is selected (121), which
indicates
th
at plan B is better, a
nd
that plan A does not make the
12
% return (JlO).
*
W.
G. Sulli van and
K.
L.
Needy, "Determ
in
ation of Economic Value Added for a Proposed Inves
Ull
ent
in
ew Manufac
tu
ring
."
Th
e
Ell
g
in
eer
in
g Economist, vo
l.
45, no. 2 (2000), pp. 1
66-
18
1.
601
~
E-Solve
0-
o
I\.)
X Microsoft Excel
I!I~Ef
Eile
~dit
Jljew
insert
FQI'mat
10015
Q.ata
:0Lindow
t!elp
.
~
.
A.
.
)I
Example n 14 !Iii!
Ef
I-"LAN
A
E
VA
anahJsis
I CF
AT
anahlsis
lnlJestment
SL
Book
valuE'
Tal!able
Ta
xes
Cost
of
Y
ear
GiI·E
P
De
reciation
8V
income,
TI
0,4
TI
NPAT
in
...
.
ca
ital
E
VA
0
(500,000)
$
500.000
$
27,000
$
(60,000) $
$
27,000
$
(
45
,00~
$
$
27,000
$
(30,000) $
27,000
$
$
170,000
$
125,000
$
375,000
$
45,000
$
18,000 I $
$
170,000
$
125.000
$
_-
250.000
$ 45,00
0...
$
18,000 $
$
170,000
$
125,000
$
125.000
$
45,000
$
18,000 $
$
170,000
I $
125,000
$ $
45,000
$
18,000 $
A'W'
..
alu~
I
11
12
PLANS
.-
---
_
13
14
I
n'''E':s:t
me
~
SL
.§:~Qk
v.a
l
ue
Ta:-lab
le
Ta!!!?
s
1~
Year
GiI·E P Oe leciation 8V
income.
TI
rO
.
4lT1
NPAT
16
0
(1,200,000)
.L
1,
200,000
17
$
600,000
$
300,000 . $ 900.000 $
30Q,QQIl....
$
18
I
$
500,000 I $
300,00
01$
--
600.000 J $
200,000 • t.
,
~
19
$
400,000
$
300,000' 1-.1.
__
- 300,000 i $
1
00,0OQ.
~
$
20
300,000
$
300,000 $ $
$
21
A'W
lJalu~s
..,?2.
23
E
25
2G
=
Sheetl
f Sheet2 f Sheet3
Ready
Figure
17-9
Comparison
of
alternatives using
EVA
a
nd
CFAT analyses, Example 17.14.
SECTION
17
.9
After-Tax Analys
is
for International Projects
CFAT evaluation:
As
shown
in
the cell tag, CFAT estimates (column
K)
are cal-
culated as GI -
E - P - taxes, Equation
I:
17.8].
The
AW
ofCFAT
(cell K21) again
concludes that plan
B
is
better and that pl
an
A does not return the after-tax
MARR
of
12% (K I
O).
(b)
What
is
the fundamental difference between the EVA and CFAT series
in
columns J
and K? They are clearly equivalent
From
the time value
of
money perspective since
the
AW
va
lu
es are numerically the same. To answer the question, consider pl
an
A,
wh
ic
h has a constant CFATestimate oF$152,
000
per year. To obta
in
the
AW
of
EVA
estimate
of
$- 12,617 for years I through 4, the initial investment
of
$500,000 is
di
st
ri
buted over the 4-year life
us
i
ng
the
A/
P factor at 1
2%
.
That
is,
an
equivalent
amount
of
$5
00,OOO(A
/ P,
l2
%,4) = $164,617
is
"c
harged" against the cash inflows
in
each
of
years I through 4. In effect, the yearly CFAT is reduced by this charge.
CFAT - (initial
in
vestmenl
)(A
/ P,
12
%,
4)
= $152,
000
- 500
,000(A/
P,
12
%,4)
J 52,000 - 164,6
17
=
$-12,617
=
AWofEVA
This is the A W value for both series, demonstrating that the two methods are eco-
nomica
ll
y equivalent. However, the EVA method indicates an alternative's yearly
estimated
co
ntribution to the
va
/u
e
of
(he corporation, whereas the CFAT method
estimates
th
e actual cash flows to the corporation. This
is
why the EVA method is
often more popular than the cash flow method with corporate executives.
Comment
The
calculation
P(A/P
,i,n) = $500,OOO(A/P,12%,4) is exactly the same as the capital
recovery
in
Equation [6.3], assuming an estimated salvage value
of
zero.
Thus
, the
cost
of
invested capital for EVA is the same as the
cap
ital
re
cove
ry discus
se
d
in
Chapter
6.
This further demonstrates why the AW method is economically equivalent to the EVA
1'-------("
evaluation.
17.9
AFTER-TAX ANALYSIS FOR INTERNATIONAL PROJECTS
Primary questions to be answered prior to performing a corporate-based after-
tax analysis for international settings revolve around tax-deductible
allowances-
depreciation, business expenses, capital asset evalua
tion-and
the effective tax
rate needed for Equation [17.6], taxes =
TI(T
e)' As discussed
in
Chapter 16, most
governments
of
the world recognize and use the straight line (SL) and declining
balance (DB) methods
of
depreciation with some variations to determine the an-
nual tax-deductible allowance.
Expense
deductions vary widely from country to
country. By way
of
example, some
of
these are s
umm
arized here.
Canada
De
pr
eciation: This is
deductib
le and
is
normally based on DB calculations,
although
SL
may be used. An
equivalent
of
the half-year
convention
is
applied in the first
year
of
ownership
.
The
annual
tax-deductible
al-
lowance
is termed capital cost allowance (CCA). As
in
the U.S. system,
603
604
CHAPTER
17
After-Tax Economic Analys
is
recovery rates are standardized,
so
the depreciation amount does not
necessarily reflect the u
sef
ul life
of
an asset.
Class
and
CCA rate: Asset classes are defined and annual depreciation rates
are specified by class.
No
specific recovery period (life) is identified,
in
part because assets
of
a particular class are grouped together and the annual
CCA
is determined for the entire class, not individual assets. There are
some
44
classes, and
CCA
rates vary from 4% per year (the equivalent
of
a
25-year-life asset) for buildings (class 1) to 100%
(I-year
life) for applica-
tions software, chinaware, dies, etc. (class 12). Most rates are
in
the range
of
10% to 30% per year.
Expenses: Business expenses are deductible in calculating TI. Expenses re-
lated to capital investments are not deductible, since they are accommo-
dated through the CCA.
In
ternet
: Further details are available on the Revenue
Ca
nada website at
www.ccra-adrc.gc.
cain
the Forms and Publications section.
Mexico
Depreciation: This is a
fu
ll
y deductible allowance for calculating TI.
The
SL
method is app
li
ed with an index for infla
ti
on considered each year. Monthly
prorated depreciation
is
used for partial-year use.
For
some
asset types, an
immediate deduction
of
a percentage
of
the first cost is allowed. (This
is
a
close equivalent to the cap
it
al
expense deduction
in
the United States.)
Class
and
rates: Asset types are identified, though not as specifically defined
as
in
some countries. Major classes are identified, and annu
al
recovery
rates vary from 5% for buildings (the equivalent
of
a 20-year
li
fe) to 100%
for environmental machinery.
Most
rates range from
10
% to
30
% per year.
Profit tax: The income tax is levied on profits on income earned from carrying
on business in Mexico.
Most
business expenses are deductible. Corporate in-
come
is
taxed only once, at the federal level; no state-level taxes are imposed.
Tax
on
Net
Assets
(TNA): A tax
of
1.8%
of
the average va
lu
e
of
assets located
in
Mexico is paid annua
ll
y
in
addition to income taxes, but income taxes
paid are credited toward the
TNA
due.
Internet:
The
best information is via websites for corporations that assist
international corporations located in Mexico.
One
example
is
Price WaterhouseCoopers at www.pwcglobal.com/rnx/eng.
Japan
De
pr
eciation: This
is
fully tax-deductible and is based on classical
SL
or
DB
methods. A total
of
95%
of
the unadjusted basis
or
first cost, as defined
in
Chapter
16,
may be recovered through depreciation, but an asset's salvage
value is assumed to
be
10
%
of
its acquisition cost.
The
capital
in
vestment
is
recovered for each asset
or
groups
of
similarly classified assets.
Class
and
life: A statutory useful
li
fe ranging from 4 to
24
years, with a 50-
year life for reinforced concrete buildings,
is
specified.
Expe
ns
es: Business expenses are deductible
in
calculating TI.