engineering economy chapter 7: depreciation lecture 13
TRANSCRIPT
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Engineering Economy
Chapter 7: Depreciation
Lecture 13
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Property is depreciable if• It is used in business or held to produce
income.• It has a determinable useful life, longer
than one year.• It is something that wears out, decays, gets
used up, becomes obsolete, or loses value from natural causes.
• It is not inventory, stock in trade, or investment property.
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Depreciable property is• tangible (can be seen or touched; personal or
real) or intangible (such as copyrights, patents, or franchises).
• depreciated, according to a depreciation schedule, when it is put in service (when it is ready and available for its specific use).
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Depreciation Methods
PURPOSE
Use a specific model to reduce the value of an
Asset (by depreciation)
or natural resource (by depletion)
TOPICS
• Depreciation terminology
• Straight line • Declining balance • MACRS• units-of-production
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Terminology
• Depreciation is the reduction in value of an asset over time
• Depreciation represents the loss in value due to: – Use, and wear and tear on the asset – Deterioration over time – Obsolescence – Technological replacement
• Depreciation represents the diminishing amount of capital invested in the asset
• Deprecation represents an amount of money charged against future income produced by the asset
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Terminology
• In most countries, depreciation is a tax deductible expense. It reduces tax liability for a corporation
• Unlike other, real expenses, depreciation is not an actual cash flow amount
Two types of depreciation used by corporations
Book depreciation -- Used internal to the corporation for financial and accounting purposes
Tax depreciation -- Per government regulations, used in calculating income taxes due
In an economic analysis, tax depreciation is usually concentrated upon
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Terminology
Time, years
BV, $
SV
First cost, B – Total cost of asset including purchase, installation, fees, etc.
Book Value, BV – Remaining, undepreciated investment after all depreciation to date is removed
Recovery period, n – Depreciable life in years. Tax and book depreciation lives often vary
Salvage, SV – Estimated market value at end of recovery period
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TerminologySome additional terms to
know
• Depreciation rate, d – fraction of first cost removed each year. (Rate is dt when it varies each year t)
• Half-year convention – assumes
asset is placed into initial service or disposed of in midyear, regardless of when it actually occurs. (Used in US-approved tax depreciation method called MACRS)
There are two types of depreciable property
Personal – Income-producing, tangible
property of a corporation, e.g., vehicles, equipment, etc.
Real – Real estate and its improvements, such as, buildings, factories, other construction
Note: Land itself is not depreciable
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Depreciation Methods
Some methods used in the US and other countries
Straight Line (SL) Standard against which other
methods are compared Book value decreases linearly
over time Declining Balance (DB)
Accelerated write-off compared to SL method
Defers part of tax liability to later in recovery period
Modified Accelerated Cost Recovery System (MACRS) Required tax depreciation
method in US since 1986
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Summary of Notation
B – First cost or basis for depreciation n – Recovery period in years SV – Estimated salvage value at end of recovery
period t – year, t = 1, 2, …, n Dt – Depreciation charge for year t Rt – Depreciation rate for year t (R, if same each
year) BVt – Book value after t years of depreciation
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Straight Line
Dt =
BVt = B - t×Dt
= BVt-1 - Dt
Rt = R = 1/n
Example: First cost is $50,000
with life of 5 years and estimated salvage of $10,000
Plot SL book value
B = $50,000 S = $10,000 n = 5 years
B – SV n
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Straight Line - Example
Year, t Dt BVt
0 $8,000 $50,000
1 8,000 42,000
2 8,000 34,000
3 8,000 26,000
4 8,000 18,000
5 8,000 10,000
SL depreciation: Dt = (50,000-10,000)/5 = $8,000
SL book value: BVt = BVt-1 – Dt
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Declining Balance (DB)
•DB write-off of asset value is accelerated compared to SL •Larger annual depreciation amounts in the early years of recovery period •Also called fixed percentage or uniform percentage method •Annual depreciation Dt equals book value at beginning of year BVt-1 (which is same as end of previous year) times fixed rate R
Dt = R× BVt-1
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Declining BalanceValues of d are related to SL depreciation rate
2 times SL rate: R = 2/n This is RMAX and is largest allowed by law If n = 5, RMAX = 2/n = 0.4 40% of BV is removed each year Known as double declining balance (DDB)
150% of SL rate: R = 1.5/n
If d is 100% of SL rate, R = 1/n, which is SL depreciation
Notation reminder: R is the fixed percentage of BV removed each year
dt is the depreciation rate for each year t
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Declining Balance
Annual depreciation determined in either of 2 ways •Using book value of previous year
Dt = R× BVt-1
•Using first cost basis B
Dt = RB(1-R )t-1
Annual book value determined in either of 2 ways Using first cost basis B
BVt = B(1-R )t
Using sum of accumulated depreciation for years i=1 to t
BVt = B – ΣDi
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Declining Balance
Characteristic book value plots of SL, DB and DDB
SL depreciation
DB depreciation at 150% SL rate
DDB depreciation
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Declining Balance
Annual depreciation rate for each year t, relative to first cost B, is
dt = RB(1-d)t-1
Salvage value is not used in DB method formulas Implied salvage is book value in year n
Implied SV = BVn = B(1-R)n
If a salvage value is estimated, and estimated SV > implied SV, stop depreciating whenever expected SV value is reached
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Declining Balance Example
P = $80,000 S = $10,000 n = 5 years Compare BV values for two methods:
DDB and DB at 150% SL rate DB rate is R=1.5/5 = 0.3 DDB rate is RMAX=2/5 = 0.4
cont →
6220.8
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Declining Balance Example
•Neither method used the estimated SV of $10,000 to calculate Dt or BVt, except …
•For DDB, depreciation in year 5 is limited, since BV5 would go below S = $10,000 •Only a $368 write-off is allowed in year 5, which is much less than the calculated amount of
D5 = R(BV4) = 0.4(10,368) = $4,147
Note: For the only US-government approved depreciation method, MACRS (covered next), the estimated S is not
used since the entire first cost B is always depreciated to zero
cont →
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Declining Balance Example
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MACRS
MACRS became the only allowed tax depreciation method in the US in 1986 Statutory depreciation rates dt are tabulated Rates are derived using the DDB or DB method initially with a switch to SL at the optimal time Recovery period n is prescribed and tabulated by asset types MACRS incorporates the half-year convention into the rates and recovery period
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MACRS
Personal Property -- Recovery periods are set at 3, 5, 7, 10, 15 and 20 years For n = 3, 5, 7, and 10 -- Depreciation rates start with DDB method, and switch to SL rates to ensure faster write-off of B For n = 15 and 20 -- Depreciation rates start with 150% DB method, and switch to SL rates to ensure faster write-off of B
Half-year convention -- Built in to allow only 50% of first year depreciation; leftover amount is removed in year n+1 (This removes some of the advantage of accelerated depreciation)
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MACRS Rates – Personal Property
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MACRS Rates – Real Property
oReal property includes buildings and permanent improvements (not land) oMACRS rates utilize SL method for n = 39 years with half-year convention built in oDepreciation rates in % are:
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MACRS - Example 1Use MACRS to depreciate asset with
B = $400,000 and n = 3 years
Year,
t
MACRS rate,
dt
Depreciation,
Dt = rate × B
Book value, BVt=BVt-1 - Dt
0 $400,000
1 0.3333 $133,320 266,680
2 0.4445 177,800 88,880
3 0.1481 59,240 29,640
4 0.0741 29,640 0
Totals $400,000
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MACRS - ExampleCompare MACRS tax depreciation with DDB book depreciation for B = $400,000 and n = 3 years
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MACRS – Example 2 Observations about MACRS and DDB methods
►MACRS always depreciates to $0; no S considered ► MACRS depreciation in year 1 is ½ the DDB or DB amount due to implicit half-year convention ► MACRS takes one additional year for write-off due to implicit half-year convention ► DDB method depreciates to an implied S value at end of the recovery period
►Book value curves vary between the two methods
0
100,000
200,000
300,000
400,000
0 1 2 3 4Year
Book value, $
DDB MACRS
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YearDepreciationCalculation
Depreciation Deduction
End-of-YearBook Value
1 $150,000 (0.2) $30,000 $120,000
2 150,000 (0.32) 48,000 72,000
3 150,000 (0.192) 28,800 43,200
4 150,000 (0.1152) 17,280 25,920
5 150,000 (0.1152) 17,280 8,640
6 150,000 (0.0576) 8,640 0
In year 4 there was a $17,280 depreciation deduction.
first cost = $150000
Use MACRS Recovery period is 5 years.
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The units-of-production method can be used when the decrease in value of the asset is
mostly a function of use, instead of time. The cost basis is allocated equally over the
number of units produced over the asset’s life. The depreciation per unit of production
is found from the formula below.
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Depreciation per unit of production =
$25, $5,
,
000 000
100 000
units
d4 = (10,000 units) ($0.2/unit) = $2,000
BV4= $25,000 - (60,000 units + 10,000 units)($0.20/unit)
= $11,000
= $0.20/unit
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TABLE 7-1 The 200% DB Method with Switchover to the SL Method (Example 7-2)
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TABLE 7-2 MACRS Class Lives and Recovery Periodsa
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TABLE 7-2 (continued) MACRS Class Lives and Recovery Periodsa
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TABLE 7-3 GDS Recovery Rates (rk) for the Six Personal
Property Classes
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TABLE 7-4 MACRS (GDS) Property
Classes and Primary Methods
for Calculating Depreciation Deductions
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Figure 7-1 Flow Diagram for Computing Depreciation
Deductions under MACRS
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Figure 7-2 BV Comparisons for Selected Methods of Depreciation in Example 7-7 (Note: The bus is
assumed to be sold in year six for the MACRS-GDS method.)
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TABLE 7-5 Corporate Federal Income Tax Rates (2006)
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Figure 7-3 The Federal Income Tax Rates for Corporations (Table 7-5) with Incremental Income Tax
for a Proposed Project (assumes, in this case, corporate taxable
income without project > $18,333,333)
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Figure 7-4 General Format (Worksheet) for After-Tax Analysis;
Determining the ATCF
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TABLE 7-6 ATCF Analysis of Example 7-15
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Figure 7-5 Spreadsheet Solution, Example 7-15
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TABLE 7-7 ATCF Analysis of Example 7-16 [Reworked Example
7-15 with Machinery in the 10-Year MACRS (GDS) Property Class]
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TABLE 7-8 After-Tax Analysis of Example 7-18
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Figure 7-6 Summary of Example 7-19
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TABLE 7-9 After-Tax Analysis of Purchase Alternative (Example 7-
19)
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TABLE 7-10 After-Tax Analysis of Design S1, Example 7-20
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TABLE 7-11 After-Tax Analysis of Design S2, Example 7-20
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TABLE P7-39 Table for Problem 7-39