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CHAPTER 16

M c. Graw. Hill. ENGINEERING ECONOMY Fifth Edition. Blank and Tarquin. CHAPTER 16. DEPRECIATION METHODS. 16 Preliminary Statement. The material presented in this chapter applies to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation.

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CHAPTER 16

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  1. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 DEPRECIATION METHODS Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  2. 16 Preliminary Statement • The material presented in this chapter applies to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation. • As such, which changing legislation, parts of this chapter could be modified by legislation enacted after publication of this text. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  3. 16 Preliminary Statement • Students are encouraged to research the current depreciation rules as they may pertain to the material in this chapter. • The IRS web site { www.irs.gov } should be accessed for IRS Publication 946 for the current rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  4. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 Learning Objectives Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  5. 16 Learning Objectives • Depreciation Terminology • Straight-Line Depreciation • Double Declining Balance Depreciation • Modified Accelerated Cost Recovery System (MACRS) • Determining the MACRS Recovery Period Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  6. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 16.1 DEPRECIATION TERMINOLOGY Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  7. 16.1 Depreciation – Definition • Depreciation is the reduction of an asset’s value over time. • Brought on by: • Wear and tear, use; • Deterioration; • Obsolescence. • Other definitions follow: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  8. 16.1 Depreciation–Definition • Depreciation – Original Reason: • Purely economic! • Economic View: • Depreciation represents a “ratable” using up of devaluation of a productive asset. • The asset must have a finite life span that can be reasonably estimated. • Deprecation represents a proper charge against future income produced by the asset in question. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  9. 16.1 Depreciation and Depletion • Depreciation provides for the retirement of a productive asset; • Depletion provides for the use of a natural resource; • Amortization recognizes a prepaid expense for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  10. 16.1 Importance of Depreciation • Federal tax law defines the concept of “taxable income” as: • Gross Income – Real Cash Expenses – interest – Depreciation amounts. • Tax Due = • {Taxable Income}(Tax Rate). • Taxes and after-tax cash flows are presented in Chapter 17. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  11. 16.1 Tax Deductions • Federal Tax law permits the reduction of Gross Income by a category of elements termed “deductions”. • Most “deductions” are real cash flows: • Wages and salaries; • Cost of materials; • Utilities; • Interest Paid on debt; • State and local taxes paid; • Etc. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  12. 16.1 Tax Equation • The General Federal Tax Equation Is: Tax. Income = Gross Income – {Real Expenses + Interest Paid + Depreciation + Depletion} All of the above amounts EXCEPT depreciation amounts and depletion amounts are real cash flow to the firm. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  13. 16.1 Non-Cash Flow Amounts • Depreciation and depletion amounts represent “non-cash flow” amounts within an accounting period. • Federal and state tax laws recognize various forms of depreciation amounts and depletions amounts to be “tax- deductible amounts,” but are not real cash flows per se. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  14. 16.1 After-Tax Cash Flows • All “for profit” firms seek to minimize legally their respective income tax liabilities. • Depreciation and depletions amounts will lower the taxable income amount and hence the tax liability if claimed. • This chapter focuses on the various forms of depreciation and depletion calculations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  15. 16.1 Depreciation Amounts • Federal tax law states that: • Any productive asset with a finite life (greater than one year) must be depreciated for tax purposes rather than “expensed” in the year of purchase. • Depreciation amounts represent a prorated amount per year that can be treated as an “expense” (deduction), but is not a real cash flow. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  16. 16.1 Tax Savings from Depreciation • Depreciation amounts represent a form of tax savings to the profitable firm. • Assume a tax rate of, say, 30%. • For every $1 of eligible deductions the resultant tax savings is: • (0.30)($1.00) = $0.30. • $1 of additional deductions saves the firm $0.30. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  17. 16.1 Simple Example • Consider a basic sewing machine that is used to sew shoes; • Assume this sewing machine sews 300,000 pairs of shoes, pair by pair. • The sewing machine is losing value over time due to the use of the machine. • An Economic Concept is at play…. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  18. 16.1 Simple Example • If the sewing machine costs $2,500 to begin with, then; • The initial cost of the sewing machine should be prorated over the 300,000 pairs of shoes. • The initial cost of the sewing machine is termed the BASIS of the asset. • One can allocate the original basis over the number of pairs of shoes the machine produces. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  19. 16.1 Types of Depreciation • Book Depreciation • Used by a firm for internal financial and managerial management. • Tax Depreciation • Used by a firm for state and federal income tax reporting. • Follows strict rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  20. 16.1 Book Depreciation • Value of the asset on the firm’s accounting records at any given point in time. • Used for internal managerial decision making. • Management is free to use any method they so choose to compute book depreciation amounts. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  21. 16.1 Book Depreciation • Used internally by the firm; • Be any method: • Straight Line, • Declining Balance; • Sum-of-the-years digits; • Other. • Defines the reduced investment in an asset based upon usage pattern and an assumed life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  22. 16.1 Tax Depreciation • Tax Depreciation: • Must follow current state and federal law pertaining to acceptable methods for computing depreciation for income tax purposes. • Federal Lever (2001) • MACRS Methods • General Depreciation System (GDS). • Alternate Depreciation System (ADS). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  23. 16.1 Book Value of an Asset • Book value: • Accounting Term, • Reflects the undepreciated (value) on the firm’s books at a given point in time. • May or may not reflect the true market value of the asset at a point in time. • Market value of an asset is what a willing buyer and willing seller agree to consummate a sale or exchange. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  24. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 DEPRECIATION TERMINOLOGY Important Terms and Their Meanings Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  25. 16.1 Terminology • The following slides state and define depreciation terminology; • Terminology is very important to the understanding of this chapter; • Please focus on the terms and their respective meanings. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  26. 16.1 BASIS of an Asset (B) Terms • The Basis of an asset is: • Purchase cost plus, • Delivery costs plus, • Installation costs and, • Any other costs associated with installing and preparing the asset for use. • To be eligible for depreciation, the asset MUST be placed in-service and ready for use. • Symbol: B for “Basis” – a dollar amount. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  27. 16.1 Book Value of an Asset (BVt) Terms • The remaining, undepreciated capital investment on the firm’s books after the accumulated amounts of depreciation have been subtracted from the original cost basis. • BV’s are usually updated at the end of the firm’s accounting year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  28. 16.1 Recovery Period - n Terms • Recovery Period (in years) is the depreciable life nof the asset in years. • Often there are different n values for book and tax depreciation. • Both of these values may be different from the asset's estimated productive life. • Also known as the Depreciable Life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  29. 16.1 Market Value (MVt) Terms • Market value, a term also used in replacement analysis, is the estimated amount realizable if the asset were sold on the open market. • Because of the structure of depreciation laws, the book value and market value may substantially differ. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  30. 16.1 Market Value (MVt) Terms • For example, a commercial building tends to increase in market value, but the book value will decrease as depreciation charges are taken. • A computer workstation may have a market value much lower than its book value due to rapidly changing technology. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  31. 16.1 Salvage Value –S Terms • Salvage value is the estimated trade-in or market value at the end of the asset's useful life. • The salvage value, S, expressed as an estimated dollar amount or as a percentage of the first cost, may be positive, zero, or negative due to dismantling and carry-away costs. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  32. 16.1 Salvage Value –S Terms • Salvage values are estimated “up-front” – at the time of the original purchase. • As an estimated value, the actual salvage value out at time t = n may or may not reflect the original estimate. • Generally speaking, one cannot depreciate an asset below its estimated salvage value. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  33. 16.1 Depreciation Rate –dt Terms • Depreciation rate or recovery rate is the fraction of the first cost removed by depreciation each year. • This rate, denoted by dt, may be the same each year, which is called the straight-line rate, or different for each year of the recovery period. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  34. 16.1 Personal Property Terms • Personal property, one of the two types of property for which depreciation is allowed, is the income-producing, tangible possessions of a corporation used to conduct business. • Not to be confused with an individual’s personal property like clothes, furniture, etc. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  35. 16.1 Personal Property – continued Terms • Included are: • most manufacturing and service industry property vehicles, • manufacturing equipment, materials handling devices, computers, and networking equipment, • telephone equipment office furniture, refining process equipment, and much more. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  36. 16.1 Real property Terms • Real property includes: • real estate and all improvements • office buildings, • manufacturing structures, • test facilities, • warehouses, • apartments, and other structures. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  37. 16.1 Real Property Terms • Real property includes real estate and all improvements – office buildings manufacturing structures, test facilities, warehouses, apartments, and other structures. • Land itself is considered real property, but it is not depreciable because it has an infinite life – land can never be depreciated for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  38. 16.1 The Half-Year Convention Terms • During a tax year, assets are purchased and installed throughout the first year. • Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year. • Under current federal tax law the first year is handled using the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  39. 16.1 The Half-Year Convention Terms • The half-year convention assumes that assets are placed in service or disposed of in midyear, regardless of when these events actually occur during the year. • This convention is utilized in this text and in most U.S.-approved tax- depreciation methods. • There are also mid-quarter and mid-month conventions. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  40. 16.1 Property Eligible for Depreciation Terms • Real or personal; • Productive assets; • Buildings and structures, but not land. • Used in the pursuit of income generation; • Have a finite, estimatable life Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  41. 16.1 Section “38” Property Terms • Often the term “Section 38,” or Section 1238,” is used: • Section 1238 (from the IRS Code, Section 1238) is defined as: • Tangible personal property (but not buildings or their structural components) that is eligible for depreciation under the federal tax code. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  42. 16.1 Code Section 1250 Property Terms • Under the IRS Code, Section 1250 property is “real” property: • Buildings and structures eligible for depreciation. • Summary: • Section 1238 – Personal Property, • Section 1250 – Real Property. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  43. 16.1 Depreciation Models • Basic (traditional) models are: • Straight-Line Method (SL), • Sum-of-the-Years Digits Method (SYD), • Declining Balance Method (DB). • Today, the MACRS Method (a form of declining balance-modified). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  44. 16.1 Classical Methods • Classical Methods (supporting Excel functions) are: • Straight-line, • SYD; • DB. • See Appendix at the end of chapter 16. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  45. 16.1 Section 179 Deduction • Section 179 Deduction: • Special provision of the tax code • Benefits the small business • Provides an economic incentive for small businesses to invest in assets required to produce a profit • Permits the “expensing” of up to a certain amount of investment in depreciable assets in a given tax year (one-year write-off). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  46. 16.1 Section 179 Allowance • The 179 allowance can reduce the current year’s income tax liability. • Has a statutory maximum: • For 2001 – max. amount = $24,000 • For 2003 – increases to $25,000. • If more than $200,000 is invested in a given year, the 179 amount is reduced dollar for dollar. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  47. 16.1 History • Before 1981 – U.S. code recognized the classical methods. • 1981 and after: • Classical methods were disallowed for federal tax purposes and replaced with a system termed ACRS – Accelerated Capital Recovery System • In 1986 ACRS was replaced with MACRS – Modified Accelerated Capital Recovery System. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  48. 16.1 Today…. • U.S. Federal Corporate Income Taxes must be computed using the MACRS system! • States that have corporate income tax laws generally permit all or part of the classical methods to be used for state corporate tax analysis. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  49. 16.1 Comparison of Methods • It is beneficial to compare: • Straight-line, • SYD, and • DB methods. • The best way is to plot the book values of each method vs. the recovery period (time). • See Figure 16.1 on page 510. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  50. 16.1 Book Value vs. Time: General Case • In general, a book value plot will look like: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

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