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TM 661 Engineering Economics

TM 661 Engineering Economics. Depreciation & Taxes. Taxable Income. + Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income. Corporate Tax Rate. Corporate Tax.

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TM 661 Engineering Economics

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  1. TM 661 Engineering Economics Depreciation & Taxes

  2. Taxable Income + Gross Income - Depreciation Allowance - Interest on Borrowed Money - Other Tax Exemptions = Taxable Income

  3. Corporate Tax Rate

  4. Corporate Tax Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.

  5. After Tax Cash Flow + Gross Income - Interest = Before Tax Cash Flow - Tax = After Tax Cash Flow

  6. After Tax Cash Flow Ex: Suppose K-Corp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the after tax cash flow.

  7. After Tax Cash Flow Gross Income $ 5,000,000 Depreciation - 800,000 Interest - 1,500,000 Before Tax Cash Flow $ 2,700,000

  8. Methods of Depreciation • Straight Line (SL) • Sum-of-Years Digits (SYD) • Declining Balance (DB) • Prior to 1981 • Accelerated Cost Recovery System (ACRS) • 1981-86 • Modified Accelerated Cost Recovery (MACRS) • 1986 on

  9. Straight Line (SLD) Let P = Initial Cost n = Useful Life s = Salvage Value year n Dt = Depreciation Allowance in year t Bt = Unrecovered Investment (Book Value) in year t Then Dt = (P - S) / n Bt = P - [ (P - S) / n ]t

  10. Ex: Straight Line Depr. Let P = $100,000 n = 5 years s = $ 20,000 Then Dt = (P - S) / n = $ 16,000 B5 = P - [ (P - S) / n ] 5 = $ 20,000

  11. Declining Balance In declining balance, we write off a constant % , p, of remaining book value D1 = pP , P = initial cost B1 = P - D1 = P - pP = P(1-p) D2 = pB1 = pP(1-p)

  12. Declining Balance In declining balance, we write off a constant % , p, of remaining book value B2 = B1 - D2 = P(1-p) - pB1 = P(1-p) - pP(1-p) = P(1-p)[1 - p] = P(1-p)2

  13. Ex: Declining Balance P = $100,000 n = 5 years S = $20,000 p = 2/5 (200% declining balance) Then D1 = (2/5)(100,000) = $ 40,000 B1 = 100,000 - 40,000 = $ 60,000 D2 = (2/5)(60,000) = $ 24,000 D5 = ? , B5 = ?

  14. Time Value of Tax Savings(Tax Rate = 40%)

  15. DDB/SL Conversion(Salvage = $0)

  16. Class Problem Ex: Suppose K-Corp is interested in purchasing a new conveyor system. The cost of the conveyor is $180,000 and may be depreciated over a 5 year period. K-Corp uses 150% declining balance method with a conversion to straight line. Compute the depreciation schedule over the 5 year period.

  17. Class Problem

  18. DDB/SL Conversion(Half-Year Convention)

  19. Class Problem A $180,000 piece of machinery is installed and is to be depreciated over 5 years. You may assume that the salvage value at the end of 5 years is $ 0. The method of depreciation is to be double declining balance with conversion to straight line using the half-year convention (you may only deduct 1/2 year of depreciation in year 1). Establish a table showing the depreciation and the end of year book value for each year.

  20. Class Problem

  21. MACRS Tables

  22. Modified Accelerated Cost Property Classes 3 yr. - useful life < 4 yrs. autos, tools 5 yr. - 4 yrs. < useful life < 10 yrs. office epuipment, computers, machinery 7 yr. - 10 < UL < 16 office furniture, fixtures, exploration 10 yr. - 16 < UL < 20 vessels, tugs, elevators (grain) 15 yr. - 20 < UL < 25 data communication, sewers, bridges, fencing

  23. MACRS (Cont.) 20 yr. - UL > 25 farm buildings, electric generation 27.5 - residential rental property 31.5 - non-residential real property Depreciation class (3, 5, 7, 10 yr.) uses 200% declining balance switching to straight-line @ optimal year class (15, 20) 150% DB switch to SLD class (27.5, 31.5) use straight-line

  24. After Tax Cash Flow Formulas BTCF = Before Tax Cash Flow = Revenues - Expenses TI = Taxable Income = Cash Flow - Interest - Depreciation Tax = TI * Tax Rate ATCF = After Tax Cash Flow = BTCF - Tax

  25. Ex: After Tax Cash Flow

  26. Borrowed Money

  27. Class Problem A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The before-tax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.

  28. Solution

  29. Solution

  30. Residential Rental

  31. MACRS - ADS Election • Straight Line with either a half-year or half-month convention. • Required for property • outside U.S. • having tax-exempt status • financed by tax-exempt bonds • covered by executive order

  32. Example Ex: A press forming machine is purchased for the manufacture of steel beams for $300,000. The press is considered a 7 year property class (MACRS-GDS = 7). Compute the annual depreciation using the MACRS Alternative Depreciation Election.

  33. Example Soln: MACRS - ADS has a longer life than does MACRS - GDS. In this case 14 years. Dn = $300,000/14 = $21,428 n = 2, . . ., 14 = $21,428 / 2 = $10,714 n = 1, 15

  34. Units of Production Method • Allows for equal depreciation for each unit of output where Ut = units produced during the year U = total units likely to be produced during life (P-F) = depreciable amount allowed

  35. Q = - t D ( P F ) t Q Operating Day Method • Allows for equal depreciation for each unit of output where Qt = total hours used during the year Q = total hours available during the year (P-F) = depreciable amount allowed

  36. R = - t D ( P F ) t R Income Forecast Method • Allows for equal depreciation for each unit of output where Rt = rent income earned during the year R = total likely rent to be earned during life (P-F) = depreciable amount allowed

  37. Depletion Method • Allows for equal depreciation for each unit of output where Vt = volume extracted during the year V = total volume available in reserve (P-F) = depreciable amount allowed V = - t D ( P F ) t V

  38. Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.

  39. Example Ex:

  40. Percentage Depletion • Depletion is taken as a constant percentage of gross income Allowable Percentages Oil/Gas 15% Natural Gas 22% Sulphur/Uranium 22% Gold, silver, … 15% Coal 10%

  41. Example Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft. Gross Income = 1.5(10,000,000) = 15,000,000 Depletion = 15,000,000 (0.22) = $3,300,000

  42. Capital Gains/Losses • Compute net long/short term gains or losses Short-term gains $20,000 Short-term losses - 28,500 Net short term loss ($ 8,500) Long term gains 85,000 Long term losses - 19,500 Net long term gain $ 65,500

  43. Gain Consolidation • Compute net long/short term gains or losses Net long term gain $ 65,500 Net short term loss ($ 8,500) Net Capital gain $ 57,000

  44. Gain Consolidation • Compute net long/short term gains or losses Net long term gain $ 65,500 Net short term loss ($ 8,500) Net Capital gain $ 57,000 Taxed as ordinary (35%) $ 19,950 Taxed at capital gain (28%) $ 15,960

  45. Example K-Corp earned $ 750,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.

  46. Example K-Corp earned $ 60,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.

  47. Example K-Corp earned $ 300,000 as ordinary income and has $100,000 in net capital LOSS. Compute the tax on the net capital gain. A Net Capital Loss may be carried back up to 3 years or carried forward up to 5 years to offset other net capital gains.

  48. Example Suppose K-Corp had the following NI, Gains, and taxes in the 3 previous years. 1995 1996 1997 Net Income 500,000 700,000 650,000 Capital Gain (80,000) 120,000 50,000 Tax 170,000 238,000 221,000 Gain Tax 0 33,600 14,000 Total Tax 170,000 271,600 235,000

  49. Example We would carry this year’s net loss back to 1996 to offset net capital gain giving 1995 1996 1997 Net Income 500,000 700,000 650,000 Capital Gain (80,000) 20,000 50,000 Tax 170,000 238,000 221,000 Gain Tax 0 5,600 14,000 Total Tax 170,000 243,600 235,000

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