Engineering Economics, 5e (Fraser)
Chapter 8 Taxes
8.1 Multiple Choice Questions
1) Why should businesses take into account tax impacts?
A) Taxes directly affect a business's cash flow.
B) Taxes increase the gross profit of a business.
C) Taxes allow the government to pay for public goods and services.
D) Taxes reduce the costs of a successful project.
E) Taxes are savings for a Canadian business.
Answer: A
Diff: 1 Type: MC Page Ref: 264
Topic: 8.1. Introduction
Skill: Recall
User1: Qualitative
2) A tax is progressive if
A) the rate of taxation increases by a constant amount with an increase in income.
B) the rate of taxation increases proportionally with an increase in income.
C) the rate of taxation increases by a constant percentage with an increase in income.
D) the rate of taxation increases faster than the income.
E) the rate of taxation increases slower than the income.
Answer: D
Diff: 1 Type: MC Page Ref: 265
Topic: 8.2. Personal income taxes and corporate income taxes compared
Skill: Recall
User1: Qualitative
3) The before-tax MARR is
A) higher than the after-tax MARR by a factor of (1 - t), where t is the corporate tax rate.
B) lower than the after-tax MARR by a factor of (1 - t), where t is the corporate tax rate.
C) higher than the after-tax MARR by a factor t, where t is the corporate tax rate.
D) lower than the after-tax MARR by a factor t, where t is the corporate tax rate.
E) approximately equal to the after-tax MARR.
Answer: A
Diff: 1 Type: MC Page Ref: 267
Topic: 8.4. Before- and after-tax MARR
Skill: Recall
User1: Quantitative
1
4) SHMON Inc. wants to invest in future projects. The before-tax MARR is 14%. The after-tax MARR
was found to be 7.4%. What is the corporate tax rate of the company?
A) 38%
B) 42%
C) 47%
D) 53%
E) 89%
Answer: C
Diff: 2 Type: MC Page Ref: 267
Topic: 8.4. Before- and after-tax MARR
Skill: Applied
User1: Quantitative
5) Which asset has the fastest depreciation rate?
A) land
B) truck
C) warehouse
D) rental car
E) office desk
Answer: D
Diff: 2 Type: MC Page Ref: 279
Topic: 8.3. Corporate tax rates
Skill: Recall
User1: Qualitative
6) What was the goal of the Canadian government in designing the Capital Cost Allowance system?
A) to calculate the total amount of taxes that the government collects from businesses' profits
B) to define the after-tax minimum acceptable rate of return that businesses can use to account for the
effects of taxation while making their investment decisions
C) to define a corporate tax rate that businesses must use while calculating the amount of their taxes
D) to define a specific amount of depreciation that businesses may claim in any year for any one
depreciable asset
E) to facilitate businesses in calculating their cash flows associated with the purchase of a long-term
depreciable asset
Answer: D
Diff: 2 Type: MC Page Ref: 276-280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
2
7) Why do businesses want to depreciate their assets as soon as possible?
A) to balance their assets and liabilities
B) to decrease the amount of taxes they must pay
C) to release funds for further reinvestment
D) to increase productivity of their operations
E) to streamline their cash flows in the long-run
Answer: B
Diff: 2 Type: MC Page Ref: 277
Topic: 8.5. The effects of taxation on cash flows
Skill: Recall
User1: Qualitative
8) The effect of taxation on annual savings is captured by
A) the capital tax factor.
B) the capital salvage factor.
C) the depreciation rate.
D) multiplying savings by the corporate tax rate.
E) multiplying savings by one minus corporate tax rate.
Answer: E
Diff: 2 Type: MC Page Ref: 271-272
Topic: 8.5. The effects of taxation on cash flows
Skill: Recall
User1: Qualitative
9) What was the major reason for the government 's introduction of the Half-Year Rule?
A) to address the problem of delivery of public goods and services
B) to address the problem of writing-off
C) to reduce business activity
D) to internalize externalities
E) to follow international practice
Answer: B
Diff: 2 Type: MC Page Ref: 280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
10) The undepreciated capital cost (UCC) is equal to
A) the book value of an asset for the purpose of taxation under the CCA system.
B) the market value of an asset.
C) the salvage value of an asset.
D) the scrap value of an asset.
E) the non-taxable value of an asset.
Answer: A
Diff: 2 Type: MC Page Ref: 280-283
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
3
11) In the CCA system "the half-year rule" implies
A) that a firm can depreciate half the remaining capital cost of an asset in any given year after the asset
is purchased.
B) that a firm can depreciate half the capital cost of an asset during the first half a year the asset is
purchased.
C) that a firm can depreciate the capital cost of an asset during the first half a year the asset is purchased.
D) that a firm can depreciate half the capital cost of a new asset in the year the asset is purchased.
E) that a firm cannot depreciate the capital cost of an asset for at least half a year after the asset is
purchased.
Answer: D
Diff: 2 Type: MC Page Ref: 280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
12) A firm has just purchased a vehicle for $100 000. The CCA rate for this vehicle is 40%. The firm's
corporate tax rate is 50%. What would be the firm's tax savings due to the CCA by the end of the first
year?
A) $5 000
B) $7 500
C) $10 000
D) $15 000
E) $20 000
Answer: C
Diff: 2 Type: MC Page Ref: 280-283
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
4
13) Sample CCA Rates and Classes are presented as follows:
CCA Rate (%) Class Description
4 to 10 1, 3, 6 Buildings and additions
20 8 Machinery, office furniture, and equipment
25 9 Aircraft, aircraft furniture, and equipment
30 10 Passenger vehicles, vans, trucks, and computers
40 16 Taxis, rental cars, and freight trucks
100 12 Dies, tools, and instruments that cost less than $200
What does the number "20" in the CCA Rate column mean?
A) A firm can claim a 20% depreciation rate per year for an asset such as machinery, office furniture,
and equipment during its service life.
B) A firm can claim a 20% depreciation rate per year for an asset such as machinery, office furniture,
and equipment beginning in the second half of the year after purchase of that asset.
C) A firm can fully depreciate an asset such as machinery, office furniture, and equipment in 5 years
from the time it is purchased using the depreciation rate of 20% per year.
D) A firm can claim a 20% depreciation rate on half of the capital cost of a new asset such as machinery,
office furniture and equipment in the year of purchase of that asset, while the other half is included in
the following year.
E) A firm can only depreciate an asset such as machinery, office furniture, and equipment with the rate
of 20% in the first year of purchase of that asset.
Answer: D
Diff: 2 Type: MC Page Ref: 279-280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
5
14) SINCO Ltd. purchased a piece of equipment in 2000. The UCC amounts for this equipment are
given in the following table:
Adjustments to
UCC from Base UCC
purchases and amounts for Remaining
Year dispositions CCA CCA UCC
2000 $200 000 $100 000 $25 000 $175 000
2001 0 $175 000 $43 750 $131 250
2002
How much could SINCO Ltd. claim as CCA in 2002?
A) $26 250.00
B) $32 812.50
C) $40 250.50
D) $62 500.00
E) $131 250.00
Answer: B
Diff: 3 Type: MC Page Ref: 280-281
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
15) A company purchased a piece of equipment in 2000. The UCC amounts for this equipment are as
follows
:
Adjustments to
UCC from Base UCC
purchases and amounts for Remaining
Year dispositions CCA CCA UCC
2000 $200 000 $100 000 $25 000 $175 000
2001 0 $175 000 $43 750 $131 250
How much tax savings could the company accumulate due to the CCA by the end of 2001 if the
corporate tax rate is 50%?
A) $12 465
B) $24 580
C) $30 925
D) $34 375
E) $68 750
Answer: D
Diff: 3 Type: MC Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
6
16) GEMTECH Ltd. is an engineering construction company. It purchased an excavator for $200 000 in
1999 and a bulldozer for $180 000 in 2000. The UCC for the changes in asset holdings due to the
purchases of an excavator are as follows:
Adjustments to
UCC from Base UCC
purchases and amounts for Remaining
Year dispositions CCA CCA UCC
1999 $200 000 $100 000 $20 000 $180 000
2000
How much could the GEMTECH Ltd. claim as CCA in 2000?
A) $36 000
B) $54 000
C) $90 000
D) $130 000
E) $270 000
Answer: B
Diff: 3 Type: MC Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
17) An engineering construction company purchased an excavator for $200 000 in 1999 and a bulldozer
for $180 000 in 2000. The UCC for the changes in asset holdings due to the purchases of an excavator
are as follows:
Adjustments to
UCC from Base UCC
purchases and amounts for Remaining
Year dispositions CCA CCA UCC
1999 $200 000 $100 000 $20 000 $180 000
2000
How much tax savings could the company accumulate due to the CCA by the end of 2000 if the
corporate tax rate is 50%?
A) $20 000
B) $28 000
C) $32 000
D) $37 000
E) $54 000
Answer: D
Diff: 3 Type: MC Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
7
18) The capital tax factor (CTF) is a value that
A) summarizes the effect of the net benefits due to CCA on the present worth of an asset.
B) summarizes the effect of the costs imposed on a firm through taxes due to CCA on the present worth
of an asset.
C) summarizes the effect of the benefits from future tax savings due to CCA on the present worth of an
asset.
D) summarizes the total effect of the taxes due to CCA on the present worth of an asset.
E) summarizes the effect of the benefits claimed as CCA on the future worth of an asset.
Answer: C
Diff: 2 Type: MC Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
19) Sirius Ltd. purchased a piece of equipment at the very beginning of the 1999 fiscal year. The UCC
amounts for this equipment are as follows:
Adjustments to
UCC from Base UCC
purchases and amounts for Remaining
Year dispositions CCA CCA UCC
1999 $40 000 $20 000 $4 000 $36 000
2000 0 $36 000 $7 200 $28 800
What was the present worth at the beginning of fiscal 1999 of the company's savings due to CCA over
the two-year period if the corporate tax rate was 25% and the interest rate was 10%?
A) $2 397
B) $2 488
C) $2 800
D) $3 214
E) $4 263
Answer: A
Diff: 3 Type: MC Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
8
20) The salvage value of a ten-year-old truck is $10 000. If this truck is on the Balance Sheet of a
transportation company as a Class 8 asset with a CCA rate of 20%, what was the present worth of this
salvage value at the time of the truck's purchase if the corporate tax rate is 35% and annual after-tax
interest rate is 5%?
A) $10 000
B) $8 200
C) $7 200
D) $6 240
E) $4 420
Answer: E
Diff: 2 Type: MC Page Ref: 284
Topic: 8.6. Present worth and annual worth tax calculations
Skill: Applied
User1: Quantitative
21) In March of 1998 a company purchased a piece of equipment for $50 000. The corporate tax rate
was and still is 30% and the after-tax MARR is 10%. What CTF should the company use if the present
worth of the first cost of this equipment, taking into account all future tax savings due to the CCA, is
$37 727?
A) 0.7018
B) 0.7213
C) 0.7425
D) 0.7545
E) cannot be determined
Answer: D
Diff: 2 Type: MC Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
22) In 2002 a firm completed the present-worth tax calculations for the value of the salvage cost of an
asset that had reached the end of its useful life. For this purpose, the firm
A) multiplied the salvage value of the asset by d, where d is a depreciation rate.
B) multiplied the salvage value of the asset by (1 - d), where d is a depreciation rate.
C) multiplied the salvage value of the asset by (1 - t), where t is a corporate tax rate.
D) multiplied the salvage value of the asset by the CTF.
E) multiplied the salvage value of the asset by the CSF.
Answer: E
Diff: 1 Type: MC Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Quantitative
9
23) DON Corporation is making a decision about a project that has an after-tax internal rate of return of
18%. If the company pays 30% corporate income tax rate what is the before-tax internal rate of return?
A) 12.6%
B) 18.0%
C) 22.4%
D) 25.7%
E) 60.0%
Answer: D
Diff: 2 Type: MC Page Ref: 275
Topic: 8.7. IRR tax calculations
Skill: Applied
User1: Quantitative
24) Numerically the relationship between the CTF and the CSF is as follows:
A) CTF is always equal to CSF.
B) CTF is always smaller than CSF.
C) CTF is always greater than CSF.
D) CTF can be smaller or greater than CSF depending on circumstances.
E) CFS = 1 - CTF.
Answer: C
Diff: 3 Type: MC Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Quantitative
25) The Capital Cost Allowance system uses a ________ depreciation rate to calculate the depreciation
allowance for capital assets.
A) proportional
B) fixed
C) straight-line
D) declining-balance
E) arbitrary
Answer: D
Diff: 1 Type: MC Page Ref: 276
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
26) The Capital Salvage Factor
A) captures the effect of taxation on an initial investment.
B) captures the effect on taxation of selling an asset for salvage.
C) captures the effect of taxation on operating costs.
D) captures the Half-Year Rule effect.
E) captures the effect of taxation on annual revenues.
Answer: B
Diff: 1 Type: MC Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
10
27) Suppose that the after-tax interest rate is 10%, and the corporate tax rate is 50%. What is the before-
tax interest rate?
A) 40%
B) 20%
C) 15%
D) 10%
E) 5%
Answer: B
Diff: 1 Type: MC Page Ref: 267-268
Topic: 8.4. Before- and after-tax MARR
Skill: Applied
User1: Quantitative
28) Suppose that a Canadian company bought a car for $20 000. The CCA rate for the car is 20% and
the corporate tax rate is 40%. How much money does the company save in the first year as a result of the
CCA allowance?
A) $2 400
B) $1 600
C) $1 200
D) $800
E) It does not save at all since it still has to pay taxes.
Answer: D
Diff: 2 Type: MC Page Ref: 276-280
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
29) At the beginning of the year, a pie company has $P in the bank. During the year it takes in $A for pie
sales. It pays $B for pie ingredients, and $C for wages and rent. It pays taxes at t%. At the end of the
year, the amount the company has in the bank is:
A) P + (A - B - C)t
B) (P + A)t - B - C
C) P + (A - B - C)(1 - t)
D) P + (A - B - C)(1 - t)
E) P + (A - B - C)t
Answer: C
Diff: 2 Type: MC Page Ref: 269-273
Topic: 8.5. The effects of taxation on cash flows
Skill: Applied
User1: Quantitative
11
30) At the beginning of the year, a pie company has $P in the bank. During the year it takes in $A for
pie sales. It pays no wages or rent. It pays taxes at t%. It buys an oven for $F. If Revenue Canada
allows ovens to depreciate at d% per year, the amount the company has in the bank at the end of the year
is:
A) P + A(1 - t) - F
B) P + (A - F)(1 - t)
C) P + A(1 - t) - F(CTF)
D) P + (A - Fd/2)(1 - t) - F + Fd/2
E) P + At - F(CTF)
Answer: D
Diff: 2 Type: MC Page Ref: 280
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
31) At the beginning of the year, a pie company has $P in the bank. During the year it takes in $A for
pie sales. It pays $B for pie ingredients, and $C for wages and rent. It pays taxes at t%. It has an oven,
purchased 10 years ago, which according to Revenue Canada rules depreciated by $D during the year. At
the end of the year, the amount the company has in the bank is:
A) P + (A - B - C - D)t
B) (P + A)t - B - C - D
C) P + (A - B - C - D)(1 - t) + D
D) P + A - (B + C + D)t
E) P + A - (B + C + D)(1 - t)
Answer: C
Diff: 2 Type: MC Page Ref: 280-283
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
32) At the beginning of the year, a pie company has $P in the bank. During the year it takes in $A for
pie sales. It pays no wages or rent. It pays taxes at t%. It has an oven, whose undepreciated capital cost
at the beginning of the year is $G. During the year it sells this oven for $G. At the end of the year, the
amount the company has in the bank is:
A) P + A(1 - t) + G
B) P + A + G(CSF)
C) P + A(1 - t) + G(CSF)
D) P + (A + G)(1 - t)
E) P + A + G(1 - t)
Answer: A
Diff: 2 Type: MC Page Ref: 266
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
12
33) At the beginning of the year, a pie company has $P in the bank. During the year it takes in $A for
pie sales. It pays no wages or rent. It pays taxes at t%. It has an oven, originally bought for $3G.
whose undepreciated capital cost at the beginning of the year is $G. During the year it sells this oven for
$2G. At the end of the year, the amount the company has in the bank is:
A) P + A(1 - t) + 2G
B) P + A + 2G(CSF)
C) P + A(1 - t) + 2G(CSF)
D) P + (A + G)(1 - t) + G
E) P + (A + g)t + G
Answer: D
Diff: 2 Type: MC Page Ref: 281-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
34) At the beginning of the year, a pie company has $P in the bank. During the year it takes in
$A for pie sales. It pays no wages or rent. It pays taxes at t%. It has an oven, originally bought for
$2G. whose undepreciated capital cost at the beginning of the year is $G. During the year it sells this
oven for $3G. At the end of the year, the amount the company has in the bank is:
A) P + A(1 - t) + 3G
B) P + A + 3G(CSF)
C) P + (A + 2G)(1 - t) + G
D) P + (A + G)(1 - t) + 2G
E) P + (A + 3G)(1 - t)
Answer: D
Diff: 2 Type: MC Page Ref: 266
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
35) The after-tax IRR is
A) always greater than the before-tax IRR.
B) equal to the before-tax IRR.
C) always smaller than the before-tax IRR.
D) equal to the before-tax IRR minus the inflation rate.
E) equal to the before-tax IRR plus the inflation rate.
Answer: C
Diff: 1 Type: MC Page Ref: 274-275
Topic: 8.7. IRR tax calculations
Skill: Recall
User1: Quantitative
13
36) A project involves an immediate expenditure of $10 000, and further expenditures of $10 000 every
year for the next four years. It will yield an income of $8 000 at the end of the first year, and this will
increase by $8 000 a year. This is the only project the company has; it is taxed at 50%, and its after-tax
MARR is 10%. Assume that losses cannot be carried forward to offset future income. What is the
present worth of the project to the company?
A) $7 452
B) $9 342
C) $12 296
D) $15 251
E) $27 552
Answer: B
Diff: 2 Type: MC Page Ref: 273-274
Topic: 8.6. Present worth and annual worth tax calculations
Skill: Applied
User1: Quantitative
37) A Canadian company buys a capital asset for $100 000. The asset depreciates at 20% per year, and
the half-year rule applies. Use of the asset brings in $5 000 a year in profit. If these are the company's
only cash flows, what is the first year in which they have to pay taxes?
A) 1
B) 2
C) 3
D) 4
E) 5
Answer: E
Diff: 2 Type: MC Page Ref: 276-283
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
38) An asset is purchased for $100 000. It depreciates at 20% per year. After 10 years it will be sold for
salvage for $10 700. If the company is taxed at 50% and has an after-tax MARR of 10%, what is the
present worth of this sale in the year of purchase?
A) $1 374
B) $2 177
C) $2 747
D) $4 125
E) $7 126
Answer: A
Diff: 2 Type: MC Page Ref: 283-284
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
14
39) A taxi company buys two new taxis at the beginning of every year. It keeps its taxis until they are
worn out and have negligible value. Each taxi costs $20 000. The company is taxed at 50%, and the taxis
depreciate at 40% per year. The company's after-tax MARR is 20%. What is the equivalent uniform
annual cost to them of buying the taxis?
A) $14 668
B) $25 333
C) $30 400
D) $40 000
E) $48 000
Answer: C
Diff: 2 Type: MC Page Ref: 283-284
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
40) A company buys 10 new computers every year for $1 200 each. They depreciate at 30% per year.
After two years they are sold for their UCC value. The half-year rule applies. If the company pays taxes
at 40% and has an after-tax MARR of 20%, what is the net present cost of buying and subsequently
selling each computer?
A) $289
B) $393
C) $412
D) $478
E) $521
Answer: B
Diff: 2 Type: MC Page Ref: 283-284
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
8.2 Short Answer Questions
1) Explain when taxes are viewed as disbursements and when as savings
Answer: When a firm makes an investment, the income from the project will affect the company’s
cash flows. If the investment yields a profit, the profits will be taxed. Since the taxes
are a direct consequence of the investment, they reduce the net profits associated
with that investment. In this sense, taxes associated with a project are a disbursement. If
the investment yields a loss, the company may be able to offset the loss from this project
against the profits from another and end up paying less tax overall. As a result, when evaluating a loss-
generating project, the net savings in tax can be viewed as a negative
disbursement. Income taxes thus reduce the benefits of a successful project, while at the
same time reducing the costs of an unsuccessful project
Diff: 2 Type: SA Page Ref: 264
Topic: 8.1. Introduction
Skill: Recall
User1: Qualitative
15
2) A manufacturing company bought a truck for $35 000. After 10 years the truck's salvage value will be
$5 000. The truck is expected to produce a revenue of $10 000 per year, while maintenance costs are
expected to be $1 000 per year. If the annual interest rate is 10%, the corporate tax rate is 35% and
straight-line depreciation is applied, what amount of taxes associated with the truck's operation will the
company pay in the first year?
Answer: Tax is imposed on net income, which is the difference between annual revenue and total annual
costs. Annual revenue is $10 000 and the total annual costs include depreciation costs plus maintenance
costs. Assuming straight-line depreciation, the annual depreciation amount is:
D= = = $3 000
Therefore, total annual costs are $3 000 + $1 000 = $4 000. The before-tax income is
(revenue - total costs) = $10 000 - $4 000 = $6 000
and the amount of tax due in the first year is 0.35 x $6 000 = $2 100
Diff: 2 Type: SA Page Ref: 267-268
Topic: 8.5. The effects of taxation on cash flows
Skill: Applied
User1: Quantitative
3) An engineering project involves the purchase of a capital asset with first cost of $100 000, operating
costs of $5 000 per year and a service life of 10 years. The expected revenue is $20 000 per year. If the
CCA rate is 25%, interest rate is 10% and the corporate tax rate is 33%, what is the project's present
worth?
Answer: The present worth of the project is:
PW (Revenue) * (1 - t) - PW(Capital costs) - PW(operating costs) * (1 - t) where t is the corporate tax
rate.
In turn, PW(Capital costs) is:
PW = CTF * 100 000 = (1 - ) * 100 000 = 0.755 x 100 000 = $77 500
Therefore:
PW(Project) = 20 000 * (P/A, 10%, 10) * ( 1 - 0.33) - 77 500 - 5 000 * (P/A, 10%, 10) * (1 - 0.33)
= 20 000 * 6.1445 * 0.67 - 77 500 - 5 000 * 6.1445 * 0.67
= 82 337- 77 500 - 20 584
= -$15 747
Diff: 1 Type: SA Page Ref: 285
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
16
4) An engineering company just bought a bending machine for $50 000. Its service life is 10 years, and
afterwards its salvage value will be $2 000. Services provided by the machine are expected to bring
$10 000 in annual revenues, and operating costs are estimated at $2 000 per year. Assume that the CCA
rate is equal to the depreciation rate, the after-tax interest rate is 5% and the corporate tax rate is 30%.
Calculate the present worth of this investment.
Answer: The depreciation rate is d = 1 - = 0.275
The present worth of the investment is:
PW = (10 000 - 2 000) x (P/A, 0.05, 10) x (1 - t) - CTF x 50 000 + CSF x 2 000 * (P/F, 0.05.10)
where t is the corporate tax rate, CTF is the capital tax factor, and CSF is the capital salvage factor.
CTF = 1 - ) = 0.7522
CSF = 1 - 0.3 * 0.275/(0.05 + 0.275) = 0.746
And the present worth of the investment is therefore
PW = 8 000 x 7.7217 x (1-0.3) - 0.7522 x 50 000 + 0.746 x 2 000 x 0.6139
= 43 241 - 37 610 + 916
= $6 547
Diff: 3 Type: SA Page Ref: 286
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
5) Calculate the CSF and CTF given the following information: the before-tax interest rate is 10%, the
corporate tax rate is 45%, the depreciation rate is 20% and the CCA rate is 25%. Which one is higher
and why?
Answer: First, it is necessary to calculate the after-tax interest rate as follows:
i = 0.1 * (1-0.45) = 0.055
The two capital cost tax factors are defined as follows:
CSF = 1 - =1- = 0.631
CTF = 1 - =1- ) = 0.641
In the above formulas, d is the CCA rate. The CTF is higher which means less tax savings under the
current Canadian Capital Cost Allowance system. This is due to the Half-Year Rule introduced on
November 13, 1981 to prevent fast depreciation of an asset in its first year.
Diff: 1 Type: SA Page Ref: 284
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
17
6) Explain why the value of IRRafter-tax calculated as IRRafter-tax ≈ IRRbefore-tax * (1 - t) is only an
approximation to the actual IRRafter-tax.
Answer: The calculated value is approximately correct because the IRR represents the percentage of the
total investment that is net income. Since the tax rate is applied to net income, it correspondingly
reduces the IRR by the same proportion. It is not exactly correct because it assumes that expenses offset
receipts in the year that they occur. It does not take into account the CCA allowance, for example.
Consequently, if the after-tax IRR is close to the after-tax MARR, a more precise calculation is
advisable.
Diff: 1 Type: SA Page Ref: 275
Topic: 8.7. IRR tax calculations
Skill: Recall
User1: Qualitative
7) What is the difference between the CCA rate and the depreciation rate, and how do the two affect
financial analysis?
Answer: The depreciation rate is used in a company's balance sheet for internal purposes. It is based on
the company's experience with capital assets of that type, and can be used to determine when the asset
should be replaced. The CCA rate is the maximum rate a company can use to depreciate its assets for tax
purposes under the Canadian Capital Cost Allowance system, and is used in calculating the company's
tax burden.
Diff: 2 Type: SA Page Ref: 271, 272
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
8) What is the undepreciated capital cost and how it is related to an asset's book value?
Answer: The book value is the current value of an asset calculated on the basis of a prescribed
depreciation method such as declining-balance depreciation. The Undepreciated Capital Cost (UCC) is
the remaining book value for the asset subject to depreciation for taxation purposes, which may differ
from its market or salvage value.
Diff: 2 Type: SA Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
18
9) Last year an engineering company earned $200 000 in annual revenues, and incurred $100 000 in
total operating costs. It also bought a new lathe for $50 000. With a CCA rate of 30% and a corporate tax
rate of 50%, how much income tax did the company pay?
Answer: Corporate tax is paid on net income (profit), which is the difference between total revenue and
total costs including depreciation. According to the Half-Year Rule, only half of a new asset's value can
be claimed in the year of the purchase. Therefore, the depreciation cost is:
* 0.3 = $7 500
Taxable net income (profit) can be calculated as follows:
Net Income = Revenue - Operating Costs - Depreciation
= 200 000 - 100 000 - 7 500 = $92 500
Taxes paid at 50% rate are 0.5 * 92 500 = $46 250.
Diff: 2 Type: SA Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
10) New Brunswick Metalworks is evaluating a $100 000 polishing machine (CCA class 8). Services
provided by the machine are expected to bring $15 000 per year in value over the next five years.
Operating costs are expected to be $1 000 per year. Calculate the amount of taxes paid in each of the
next five years of service life under the corporate tax rate of 40%.
Answer: All calculations are summarized in the following table:
Operating Depreciation
Year Revenue cost cost Net income Tax
1 $20 000 $1 000 $10 000 $9 000 $3 600
2 $20 000 $1 000 $18 000 $1 000 $400
3 $20 000 $1 000 $14 400 $4 600 $1 840
4 $20 000 $1 000 $11 520 $7 480 $2 992
5 $20 000 $1 000 $9 216 $9 784 $3 913
In the first year, depreciation cost is calculated according to the Half-Year Rule. In all other consecutive
years, the undepreciated capital cost is calculated first as
UCC(t) = UCC(t - 1) - UCC(t - 1) * CCA rate
and then depreciation cost is defined as
UCC(t) * CCA rate
where CCA rate is 20% (Table 8.4, page 279).
Diff: 3 Type: SA Page Ref: 280-282
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
19
11) Explain the problem of "writing-off" and how the introduction of the Half-Year Rule addressed this
problem.
Answer: Prior to November 12, 1981, a company was allowed to include in its base for the calculation
of capital cost allowance the full purchase price of an asset purchased within the year, regardless of
when in the year the asset was purchased. Consequently, there was considerable motivation for
companies to purchase assets at the end of the fiscal year and claim their full value as depreciation
amount. This was known as the problem of writing-off. The Canadian government, recognizing the
problem, changed the rules effective November 13, 1981. Since that date, only half of the capital cost of
acquiring an asset is considered in the Capital Cost Allowance system in the year of purchase of an
asset, while the other half is then included in the second year. Since the change, there still remains an
incentive to purchase equipment at the end of the fiscal year, however, the incentive has been reduced as
the tax effects have been diminished.
Diff: 1 Type: SA Page Ref: 280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
12) A manufacturing company just bought a new piece of equipment for $1 million. It is a class 8 asset.
The following information is given:
- after-tax annual interest rate = 8%
- corporate tax rate = 36%
- service life = 10 years
- historic depreciation rate = 25%
Calculate the present worth of the equipment's salvage value with tax effects.
Answer: First of all, it is necessary to calculate salvage value of the asset using its historic depreciation
rate:
S = BV(10) = P * (1 - d)10 = 1 000 000 * (1 - 0.25)10 = $56 313.51
Present worth of the salvage value with tax effects can be defined as:
PW(S) = S * CSF * (P/F, 8%, 10)
where CSF is the capital salvage factor. Note that in calculating CSF, we don't use the historic
depreciation rate, but the depreciation rate prescribed by Revenue Canada for Class 8 assets, which is
20%.
CSF = 1 - =0.74286
Therefore:
PW(S) = 56 313 * 0.74286 * = $19 376
Diff: 2 Type: SA Page Ref: 285
Topic: 8.8. Specific tax rules in Canada
Skill: Applied
User1: Quantitative
20
13) An oil company uses a technology which it purchased for $15 million. Operating costs are $2
million per year, and output is 1 000 barrels per day. Calculate the after-tax IRR given the following
information: The corporate tax rate is 25%, the price of oil is $20 per barrel, the service life of the
technology is 5 years and salvage value is $2 million. If the after-tax MARR is 15%, is this a good
investment?
Answer: The after tax IRR is
IRRafter = IRRbefore x (1-t)
where t is the corporate tax rate. Therefore, first it is necessary to calculate the before-tax IRR. By
definition of the IRR:
20 * 1 000 * 365 * (P/A, IRRbefore, 5) + 2 000 000 * (F/A, IRRbefore, 5)=15 000 000 + 2 000 000
(P/A, IRRbefore, 5).
and IRRbefore ≈ 0.247. Therefore the after-tax IRR is
IRRafter = 0.247 x (1-0.25) = 0.185 or 18.5%.
Since the after-tax IRR exceeds the after-tax MARR, this is a good investment.
Diff: 3 Type: SA Page Ref: 275-276
Topic: 8.7. IRR tax calculations
Skill: Applied
User1: Quantitative
14) Explain the main objective of the Canadian Capital Cost Allowance system and its basic
assumptions.
Answer: In order to limit the depreciation amount which companies use for tax purposes, the Canadian
government established a maximum level of depreciation which a company can claim each year. This
maximum amount is referred to as the firm's capital cost allowance (CCA). The CCA system specifies
the amount and timing of depreciation expenses on capital assets. According to the CCA system, the
declining-balance method of depreciation must be used for claiming capital costs associated with most
tangible assets. Straight-line depreciation is used for intangible assets.
Diff: 1 Type: SA Page Ref: 276-280
Topic: 8.8. Specific tax rules in Canada
Skill: Recall
User1: Qualitative
21
15) Explain why it is important to incorporate tax impacts into a business's cash flows.
Answer: Taxes can have a significant impact on the economic viability of a project because they change
the actual cash flows experienced by a business. A vital component of a thorough economic analysis
should therefore include the tax implications of an investment decision. When a business makes an
investment, the income from the project will affect the business's cash flows. If the investment yields a
profit, the profits will be taxed. Since the taxes result as a direct consequence of the investment, they
reduce the net profits associated
with that investment.
Diff: 1 Type: SA Page Ref: 264
Topic: 8.2. Personal income taxes and corporate income taxes compared
Skill: Recall
User1: Qualitative
22
