EGGC4214 Systems Engineering & Economy Lecture 8 Depreciation

1. EGGC4214 Systems Engineering & EconomyLecture 8Depreciation

2. Introduction Depreciation is important because it affects the taxes that firms pay. TAXES proportional to TAXABLE PROFITS (INCOME – COSTS) COSTS = Maintenance Cost + Depreciated Initial Cost Roughly speaking, depreciation is a decrease in value of an asset each year. Depreciation is a deduction from taxable income. Thus the greater the depreciation, the less the taxable income – hence taxes. Governments may allow some choice among depreciation methods. Obviously, a well-run firm wants to choose the depreciation method that will minimize its taxable income. To do so, the firm representatives must understand how the depreciation methods work.

3. Depreciation: Example A firm has $1,000,000 of taxable income. If its tax rate is 25%, it would pay $250,000 in taxes ignoring depreciation. If it can deduct $50,000 in depreciation charges, its net taxable income is $950,000. Thus, it would pay taxes of 0.25 (950,000) = $237,500. Depreciation saves 250,000 – 237,500 = $12,500 = 0.25(50,000). If it could deduct more than $50,000 it would pay even less taxes. Individual investors encounter similar situations. If you invest $10,000 and get a 10% return, your taxable income is $1,000. If you are in the 25% tax bracket, taxing takes $250, so your net return is $750  7.5%. If you could have found an 8% investment for your $10,000 that was not taxable, you would have made a better choice (800 > 750).

4. Depreciation Market value is the value others would place on the property of interest Depreciation can mean • a decrease in market value, • a decrease in the value to the owner. Important reasons for depreciation include • deterioration, • obsolescence. Accountants define depreciation as follows: the systematic allocation of the cost of an asset over its useful, or depreciable, life. The latter definition is used for determining taxable income – hence, income taxes. Thus, this definition is most important to us. A machine can begin to wear out and no longer perform its function as well as when it was new.

5. Depreciation: Requirements In general, business assets can only be depreciated if they meet the following basic requirements: • The property must be used for business purposes to produce income • The property must have a useful life that can be determined, and this life must be longer than one year • The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner from natural causes

6. Depreciation Example: Joe’s Pizza Joe runs a pizza parlor. He classifies some of his cost items as follows. • Req. for Depreciation: • 1. The property must be used for business purposes to produce income • The property must have a useful life that can be determined, and this life must be longer than one year • The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner from natural causes Expensed Items: Labor, Utilities, Materials, Insurance Expensed items are (often recurring) expenses in regular business operations. They are consumed over short periods (e.g., monthly or biweekly salaries). Expenses are subtracted from business revenues for tax purposes. Expenses reduce income taxes at the time period when they occur. Depreciated Items: van, furniture, baking oven, cash register, computer. Usually you pay for the asset “up front”, but depreciate it over time. 

7. Depreciation: Overview Definition. The number of years over which a machine is depreciated is called its depreciable life or recovery period. This period may differ from the useful life - The depreciation method determines the depreciable life. At least six different depreciation methods are available. • Depreciation is a non-cash cost. No money changes hands. • Depreciation is a business expense the government allows to offset the loss in value of business assets. • Usually you pay for the asset “up front”, but depreciate it over time (e.g., a new truck). • Depreciation deductions reduce the taxable income of businesses and thus reduce the amount of tax paid.

8. Classes of Business Property Classes of Business Property • Tangible property can be seen, touched, and felt. • Real property (think “real estate”) includes land, buildings, and all things growing on, built on, constructed on, or attached to the land. • Personal property includes equipment, furnishing, vehicles, office machinery, and anything that is tangible excluding those assets defined as real property. (Note “personal” does not refer to being owned by a person or being private). • Intangible property is all property that has value to the owner but cannot be directly seen or touched. Examples include patents, trademarks, trade names, and franchises. Examples of depreciable business assets: • Copy machines, Helicopters, Buildings, Interior furnishing, Production equipment, Computer networks Many different types of properties that wear out, decay, or lose value can be depreciated as business assets. Examples of nondepreciable business assets: • Land: it does not wear out, lose value, or have a determinable useful life. Indeed, often it increases in value. • Leased property: only the owner of property may claim depreciation expenses. Sometimes tangible property is used for both business and personal activities, such as a home office. The depreciation deduction can be taken only in proportion to the use for business expenses.

9. Depreciation Calculation Fundamentals Example. A PC costs $1,800. Its annual depreciation charges are $800, $600, and $350 for three years. $1,800 is called the cost, initial cost, or cost basis. dt denotes the depreciation deduction in year t. Thus d1 = $800, d2 = $600, and d3 = $350. BVt denotes the book value at the end of year t. BV0 = cost basis (e.g., $1,800) BV1 = BV0 – d1 = cost basis – d1 (e.g., $1,000) BV2 = BV1 – d2 = cost basis – (d1 + d2) (e.g., $400) BV3 = BV2 – d3 = cost basis – (d1 + d2 + d3) (e.g., $50)

10. Depreciation Calculation Fundamentals BVt = cost basis – (d1 + d2 + … + dt) This equation is used to compute the book value of an asset at the end of any time t. Book value can be viewed as the remaining unallocated cost of an asset: Book value = Cost – Depreciation charges made to date Note: If the item has a salvage value then the final book value will be the salvage value. Example: The book value of the PC declines during the useful life from a value of B = $1,800 at time 0 in the recovery period, to a value of S = $50 at time 3. Numerous depreciation methods are possible.

11. Straight Line (SL) Depreciation Example An asset has a cost of B = $900, a useful life of N = 5 years, and an EOL salvage value of S = $70. With SL depreciation, the following is found: Annual depreciation charge: di = (B-S)/N = 830/5 = $166. The book value of the asset decreases by $166 each year Initial Cost Book Value 900 Salvage Value 70 1 2 3 4 5 N Useful Life

12. Straight Line (SL) Depreciation Example. Depreciation to Intangible Property Veronica’s firm bought a patent in April, 1st. It was not acquired as part of acquiring a business. The firm paid $6,800 for the patent. They must depreciate it using SL depreciation over 17 years, with no salvage value. Annual depreciation is $400 = $6,800/17. The firm bought the patent in April, 1st. This means the depreciation for the first year must be prorated over the 9 months of ownership. Therefore the first year depreciation is (9/12)  400 = $300. In later years the depreciation can be $400. For the last 3 months of depreciation life = (3/12)  400 = $100. Straight line depreciation is the simplest and best known: C = Annual depreciation charge = (B-S)/N.

13. Year Life, FOY Multiplier B - S Depreciation Charge EOY Book Value 0 $900 1 5 5/15 $830 $277 623 2 4 4/15 830 221 402 3 3 3/15 830 166 236 4 2 2/15 830 111 125 5 1 1/15 830 55 70 15 1 $830 Sum-Of-Years Digits (SOYD) Depreciation Example An asset has a cost of B = $900, a useful life of N = 5 years, and an EOL salvage value of S = $70. With SOYD depreciation, we would compute the following: The product of the multiplier and B-S for the year is the depreciation charge for the year. Note the multipliers add to 1.

14. Sum-Of-Years Digits (SOYD) Depreciation dt=(N+1-t)/SOYD(B-S)= 2(N+1-t)/[N(N+1)](B-S) Book Value SOYD depreciation causes larger decreases in book value in earlier years than in later years. Question. If you were a firm, would you prefer SOYD or SL depreciation? SOYD Depreciation looks like this $S N

15. Declining Balance Depreciation For straight line depreciation with N years, the rate of decrease each year is 1/N. Declining balance depreciation uses a rate of either 150% or 200% of the straight-line rate. Since 200% is twice the straight-line rate, it is called double declining balance (DDB). The DDB equation for any year is DDB depreciation dt = (2/N) ( Book value)  Book value = Initial cost – total charges to date,  So, DDB deprec. dt = (2/N) (Initial cost – total charges to date) It can be shown for DDB, that the depreciation schedule in year t is given by: DDB depreciation in year t = (2B/N)(1 – 2/N)t-1 For 150% declining balance depreciation, the depreciation in year t is given by: DDB depreciation in year t =(1.5 B/N)(1 – 1.5/N)t-1.

16. Declining Balance Depreciation: Example Example An asset has a cost of B = $900, a useful life of N = 5 years, and an EOL salvage value of S = $70. With DDB depreciation, we would compute the following: • If the salvage value of this example had not been $70, a modification of DDB would be necessary. • Several possibilities exist: • stop further depreciation when the book value equals the salvage value; • “switch over” from DB depreciation to straight line.

17. Modified Accelerated Cost Recovery System(MACRS) Depreciation • This is the newest depreciation method that can be used for income taxing purposes. • The computations are made using “property class lives” that are less than the “actual useful lives.” • In 1971, the U. S. Treasury Department published guidelines for about 100 broad classifications of depreciable assets. For each classification, there were lower limit, midpoint, and upper limit of useful life. This life is called the Asset Depreciation Range (ADR). The ADR midpoint lives were somewhat shorter than the actual average useful lives.

18. MACRS Depreciation Example Class Lives and MACRS Property Classes ADR: Asset Depreciation Range; GDS: general depreciation system ADS: alternative depreciation system GDS is based on declining balance with a switch to straight line depreciation. ADS uses SL depreciation and provides for a longer period of recovery. It is less economically attractive than GDS. a) Any tangible property used primarily outside of the U.S. b) Any property that is tax-exempt or financed by tax-exempt bonds c) Farming property placed in service when uniform capitalization rules are not applied

19. MACRS Depreciation MACRS has major advantages: 1. The computations are made using “property class lives” that are less than the “actual useful lives”. 2. Salvage values are assumed to be zero. 3. Tables of annual percentages simplify computations. Steps in Depreciation a) Determine that the property is eligible for depreciation. b) Calculate its depreciation deductions over its life, using • the cost basis of the property; • the property class and recovery period of the asset; • the asset’s placed-in-life service date (1) Cost Basis. The cost basis B is the cost to obtain and place the asset in service fit for use.For real property the basis may also include certain fees and charges the buyer pays as part of the purchase, e.g., legal and recording fees, abstract fees, survey charges, transfer taxes, title insurance, and amounts the seller owes that you pay (such as back taxes). (3) Placement In Service. If the asset is a business asset, depreciation begins when the asset is placed in service.

20. MACRS Depreciation

21. MACRS Depreciation How to compute the year-to-year depreciation deductions for GDS assets, given the MACRS property class, the placed-in-service date, and cost basis? Use, for each year t, dt = B  rt where dt = depreciation deduction in year t B = cost basis being depreciated rt = appropriate MACRS percentage rate

22. MACRS Depreciation Book value SL DB time Book value SL DB time

23. MACRS Depreciation How are MACRS Percentage Rates developed? MACRS is basically a combination of DB and SL methods. It starts out as a DB method and then switches over at some point to SL. Three assumptions are important: 1. Salvage values are zero for all assets. 2. The first and last years of the recovery period are each ½ years. 3. The DB rate is 200% for 3,5, 7 and 10 year property; it is 150% for 15 and 20 year property. A 5-year MACRS property asset has an installed and “made ready for use” cost basis of $100.

24. MACRS Depreciation: Example Use the MACRS GD method. Calculate the yearly depreciation allowances and book values for a firm that has purchased $150,000 worth of office equipment. The equipment qualifies as depreciable property. Estimated salvage value is $30,000. Input Data 1. The assets qualify as depreciable property 2 B = $150,000 3. The assets placed in service in year 1 4. MACRS GD applies 5. Ignore the salvage value (0 with MACRS) Look up office equipment in Table in page 20 as 7-year property. Then obtain the MACRS percentages from Table in page 21. Then use the following equation to compute depreciation amounts: BVt = cost basis – (d1 + d2 + … + dt)

25. Unit of Production Depreciation Occasionally the recovery of depreciation on an asset is more closely related to use than time. In such a case we can use Unit of Production (UOP) depreciation: For any year, do the following: 1. Compute the ratio of the yearly production of the asset to its total lifetime production. 2. Multiply the ratio and (B-S) to get UOP. This method is not acceptable for general use in depreciating industrial equipment. It might be useful for machinery that processes natural resources when the resources are exhausted before the machinery wears out. Example: Asset cost B = $900. Salvage value S = 70. The equipment will be used in a sand and gravel pit. The pit will be in operation during a five-year period while a nearby airport is built. After that time, the pit will be shut down, and the equipment removed and sold. The airport will need 40,000 cubic meters of sand and gravel. B-S = $830. The actual UOP depreciation charge in any year is based on the actual production for the year, and not the scheduled production.