mer1601 mer 160 - design of thermal fluid systems engineering economics – depreciation methods...
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MER160 1
MER 160 - Design of Thermal Fluid Systems
Engineering Economics – Depreciation Methods
Professor BrunoWinter Term 2005
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MER160 2
Depreciation
• Reduction in the value of an asset with time
• “Book Depreciation:” used by a business to keep track of the value of their assets at any given time
• “Tax Depreciation:” Used to determine write-offs against income caused by depreciation. MUST BE DONE USING A GOV’T APPROVED METOD
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MER160 3
Concepts of Value• Market Value
– Price at which property could actually be sold
• Value to owner– Money amount that would be sufficient to
compensate owner if the owner were to be deprived of the property
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MER160 4
Depreciation TerminologyDepreciation: reduction in the value of an asset
using (government) approved rules
Dt: depreciation amountB: first cost (installed cost of asset)
(Also called the “Unadjusted Basis” or simply “Basis” … hence the “B”)
BVt: book value - represents the remaining un-depreciated investment (value) on the
books. Determined at the end of the year
Note the “t” subscript refers to “time” in years
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MER160 5
Depreciation Terminology
n: recovery period (depreciable life of asset in years)
dt: depreciation rate (fraction of first cost removed by depreciation in a given year).
SV: salvage value (estimated market value at the end of an asset’s useful life).
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MER160 6
Depreciation TerminologyDepreciation is allowed for two types of property:
Personal Property: income producing tangible possessions of a corporation used to conduct business
Real Property: real estate buildings etc (land is not depreciable)
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MER160 7
Methods of Depreciation Accounting
(1)Accelerated methods - give a greater write off in the early years (declining balance, MACRS)
(2) Uniform Methods - give a uniform write off throughout the entire service life. (straight-line)
(3) Decelerated Methods - give a smaller write off in the early years. (sinking fund)
CHOICE IS INFLUENCESD BY TAX LAWS
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MER160 8
Straight Line Depreciation
Dt is the depreciation charge in year t and BVt is the book value at the end of the tth year after the depreciation charge has been made.
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MER160 9
SL Depreciation Example
Consider a machine tool with a first cost of $35,000 an estimated life of 20 years and an estimated salvage value of $3,500. Use SL depreciation and calculate the depreciation charge and the book value of the machine tool after 4 years.
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MER160 10
SL Depreciation ExampleB = $35,000SV = $3500n = 20
= 1/20 = 0.05
=0.05*(35000-3500) =$1575
= $35000 – 4($1575) = $28700
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MER160 11
Declining Balance DepreciationAssets are commonly worth more in initial years – it is sensible to write off costs more rapidly in the early years.
Declining Balance: a given depreciation rate (d) is applied to the remaining book value each year.
i.e. 10% applied to a $35,000 asset
1st year Dt = 0.01*(35000) = 3500
2nd year Dt = 0.10*(35000-3500) = 3150
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MER160 12
Declining Balance DepreciationThe maximum allowable percentage is double the straight line rate: (also called Double Declining Balance or DDB method)
dmax = 2/n
The actual depreciation rate is dt = d*(1-d)t-1
Dt = d*BVt-1
Dt = d*B*(1-d)t-1
BVt = B*(1-d)t
With the DB method the BV never goes to zero.However, no asset can be depreciated below the SV!
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MER160 13
DB Depreciation Example
Assume that an asset has a first cost of $25,000 and an estimate salvage value of $4000 after 12 years, Calculate its depreciation and book value for (a) year one and (b) year four using the DDB method.
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MER160 14
DB Depreciation Example
First Compute the depreciation rate:
d = 2/n = 2/12 = 0.1667
(a) For the first year: D1 = = 0.1667*25000*(1-0.1667)1-1=$4167
BV1 = 25000*(1-.01667)1 = $20,832.50
Year 4 D = 2411.46, BV = 12,054
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MER160 15
MACRS Economic Reform Act (1981) – ACRS
Tax Reform Act (1986) - MACRS
• Applies to property placed in service after 12/31/86
• Doesn’t use useful life or SV
• Property is organized into ASSET Classes and assigned a Class Life.
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MER160 16
MACRS
Dt = dt*B
(dt is set by the government)
BVt = BVt-1-Dt
The first cost is always completely depreciated – assumes SV = 0
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MER160 17
MACRS Depreciation Example
Calculate the depreciation charge and book value for an asset worth $100,000 using MACRS depreciation with a three year recovery period.
year d D BV0 100,000.00$ 1 0.333 33,300.00$ 66,700.00$ 2 0.445 44,500.00$ 22,200.00$ 3 0.148 14,800.00$ 7,400.00$ 4 0.074 7,400.00$ -$