MIT 22 812J - Capital Costs: Capitalization, Depreciatiion and Taxation

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Capital Costs: Capitalization, Depreciation and Taxation February 23. 2004 2/23/04 Nuclear Energy Economics and Policy Analysis 1From an accounting perspective, there are two categories of costs: • ‘Expensed’ costs – Items that are used up quickly; costs recovered out of current revenues • ‘Capitalized’ costs – Long lifetime items; costs recovered progressively throughout the expected lifetime 2/23/04 Nuclear Energy Economics and Policy Analysis 2------Depreciation Example: Pizza Delivery Business Sales: $20,000/yr Car purchase: $6,000 Operating expenses: $10,000 Car lifetime: 4 yrs Net salvage value: $0 Income statements (I): Expensing the car purchase Year 1 Year 2 Year 3 Year 4 Operating Revenues 20,000 20,000 20,000 20,000 Operating Expenses 10,000 10,000 10,000 10,000 Car Purchase 6,000 Operating Income 4,000 10,000 10,000 10,000 (=operating revenues – operating expenses) Net Cash Flow 4,000 10,000 10,000 10,000 2/23/04 Nuclear Energy Economics and Policy Analysis 3Income Statements (II): Capitalizing the car purchase & straight-line depreciation Year 1 Year 2 Year 3 Year 4 Operating Revenues 20,000 20,000 20,000 20,000 Operating Expenses 10,000 10,000 10,000 10,000 Operating Income 10,000 10,000 10,000 10,000 Depreciation allowance 1500 1500 1500 1500 Net income (before 8,500 8,500 8,500 8,500 taxes) = Operating income – depreciation allowance Net cash flow 4000 10,000 10,000 10,000 2/23/04 Nuclear Energy Economics and Policy Analysis 4Income statements (III): Expensing the car purchase; taxes included Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Car Purchase 6000 Op. Income (OI) 4000 10000 10000 10000 Taxable Income (TI) 4000 10000 10000 10000 (= OR-OE-‘other deductible items’) Taxes (T= TI*t) 1200 3000 3000 3000 (t = 30%) Net Income After 2800 7000 7000 7000 Taxes (=TI – T) Net Cash Flow 2800 7000 7000 7000 (= Total cash in – total cash out) 2/23/04 Nuclear Energy Economics and Policy Analysis 5Income Statements (IV): Capitalizing and depreciating the car purchase; taxes included (Straight-line depreciation assumed) Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Op. Income (OI) 10000 10000 10000 10000 Depreciation Allowance (D) 1500 1500 1500 1500 Taxable Income 8500 8500 8500 8500 (TI = OR-OE-D) Taxes (T= TI*t) 2550 2550 2550 2550 (t = 30%) Net Income After 5950 5950 5950 5950 Taxes (ATNI =TI – T) Net Cash Flow 1450 7450 7450 7450 (NCF = Total cash in – total cash out) 2/23/04 Nuclear Energy Economics and Policy Analysis 6Expensing the car cost Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Car Purchase 6000 Op. Income (OI) 4000 10000 10000 10000 Taxable Income (TI) 4000 10000 10000 10000 (= OR-OE-‘other deductible items’) Taxes (T= TI*t) 1200 3000 3000 3000 (t = 30%) Net Cash Flow 2800 7000 7000 7000 (= Total cash in – total cash out) Total taxes = $10200 Net Income After 2800 7000 7000 7000 Net Income After 5950 5950 5950 5950 Taxes Taxes (=TI – T) (ATNI =TI – T) Depreciating the car cost Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Op. Income (OI) 10000 10000 10000 10000 Depreciation 1500 1500 1500 1500 Allowance (D) Taxable Income 8500 8500 8500 8500 (TI = OR-OE-D) Taxes (T= TI*t) 2550 2550 2550 2550 (t = 30%) Net Cash Flow 1450 7450 7450 7450 (NCF = Total cash in – total cash out) Total taxes = $10200 2/23/04 Nuclear Energy Economics and Policy Analysis 7Expensing the car cost Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Car Purchase 6000 Op. Income (OI) 4000 10000 10000 10000 Taxable Income (TI) 4000 10000 10000 10000 (= OR-OE-‘other deductible items’) Taxes (T= TI*t) 1200 3000 3000 3000 (t = 30%) Net Cash Flow 2800 7000 7000 7000 (= Total cash in – total cash out) Net Income After 2800 7000 7000 7000 Net Income After 5950 5950 5950 5950 Taxes Taxes (=TI – T) (ATNI =TI – T) NPV(@10%/yr) = -6000 + 8800/1.1 + 7000/1.12 + 7000/1.13 + 7000/1.14 = $17,825 Depreciating the car cost Year 1 Year 2 Year 3 Year 4 Op. Revenues (OR) 20000 20,000 20,000 20,000 Op. Expenses (OE) 10000 10,000 10,000 10,000 Op. Income (OI) 10000 Depreciation Allowance (D) 1500 10000 1500 10000 1500 10000 1500 Taxable Income (TI = OR-OE-D) 8500 Taxes (T= TI*t) (t = 30%) 2550 8500 2550 8500 2550 8500 2550 Net Cash Flow (NCF = Total cash in – total cash out) 1450 7450 7450 7450 NPV(@0%/yr) = -6000 + 7450/1.1 + 7450/1.12 + 7450/1.13 + 7450/1.14 = $17,615 Conclusion: On an after-tax NPV basis, the business would prefer to expense the car cost. But this is not permitted by the IRS! 2/23/04 Nuclear Energy Economics and Policy Analysis 8Example: Capitalizing and depreciating the car; debt financing Sales: $20,000/yr Car purchase: $6,000 Operating expenses: $10,000 Car lifetime: 4 yrs Net salvage value: $0 Car loan: $4000 Loan term: 4 years Repayment: Equal principal repayments at end of year 2/23/04 Nuclear Energy Economics and Policy Analysis 9Income Statement: Capitalization and (straight line) depreciation of the car + debt financing T=0 End of Year 1 End of Year 2 End of Year 3 End of Year 4 Operating Revenue (OR) 20000 20000 20000 20000 Operating Costs (OC) 10000 10000 10000 10000 Operating Income (OI = OR-OC) 10000 10000 10000 10000 Depreciation allowance (D) 1500 1500 1500 1500 Interest payment (IP) 400 300 200 100 Taxable income 8100 8200 8300 8400 (TI = OI – D – IP) Taxes (@ 30% of TI) 2430 2460 2490 2520 After-tax net income 5670 5700 5730 5760 Principal repayment (PR) 1000 1000 1000 1000 Net cash flow -2000 6170 6240 6310 6380 (NCF = OR – OC – IP – PR) 2/23/04 Nuclear Energy Economics and 10 Policy Analysis2/23/0411Sunset Inc.INCOME STATEMENT & RETAINED EARNINGS(For Year Ended December 31, 20xx)Income statementNet salesSales & other operating revenueLess sales return & allowancesCost of goods soldLaborMaterialsOverheadDepreciationTotalGross profitOperating expensesSellingGeneral administrationLease paymentsTotalNet operating profitNonoperating


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MIT 22 812J - Capital Costs: Capitalization, Depreciatiion and Taxation

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