Chap 10

Depreciation is a decline in market or asset value ofphysical properties caused by deterioration or obsolescence. It represents a legal loss of value for tax purposes. Depreciation involves a systematic allocation of the cost of an asset over its depreciable life. The annual depreciation expense is deductible for income tax calculations.

EGR 403, Jan 99

Depreciable property* Tangible

1) Real 2) Personal* Intangible

To be depreciable:•must be used in business•determinable life > 1 year•wears out

Consider period of service not period of ownership

EGR 403, Jan 99

Definitions of Value* Market Value: Cost of a property when both buyer and seller have equal advantage and are under no compulsion to buy or sell.* Salvage (resale) Value (S): Price that can be obtained from the sale of the property* Book Value: Original cost (P) of a property less the amounts that have been charged as depreciation expense.* Adjusted Basis Value: Book value plus the cost of improvements, additions, and other capital costs, commissions, legal fees, etc. minus certain credits. This value is essential in calculating the taxable profit or loss from the sale of property.

EGR 403, Jan 99

Income Statement Jan. 1 to Dec. 31, 2000

Revenue $300,000Expenses:

Depreciation $60,000Expenditures $90,000

Taxable income $150,000Income tax $40,000Net income after tax $110,000

Engineering Economy:Revenue $300,000Less expenditures $90,000Cash flow before tax $210,000Less tax $40,000Cash flow after tax $170,000EGR 403, Jan ‘00

Notations:P: initial cost, S: salvage value, N: useful life

Depreciation Methods: Straight line (S.L.) Depreciation:Annual depreciation charge = (P-S)/N Book value at end of year n = P - n(P-S)/N n = 1......NSum-of-Years Digits (SOYD) DepreciationSum-of-Years Digits = SOYD = N(N+1)/2Depreciation for year n = (N-n+1)[(P-S)/SOYD]Declining Balance Depreciation:DDB Depreciation in any year = 2(Book Value)/N= 2(Cost - Depreciation charges to date)/NImplied Salvage value at the end of N years = P(1 - 2/N)EGR 403, Jan 99

Modified Accelerated Cost Recovery System (MACRS)The newest depreciation method that may be used for U.S. income tax purposes.

Assumptions:DDB with switch to SL, zero salvage value, midpoint life

Steps:1) Determine the property class of the asset.2) Read the depreciation percentages from the table.

EGR 403, Jan 99

To calculate tax:

1- Find taxable income *For individuals = Adjusted gross income - Personal exemptions - Itemized deductions or Standard deductions

*For business = Gross income - Expenditures (not capital) - Depreciation

2- Use related tax rates table Find the tax bracket and use its marginal tax rate

EGR 403, Jan 00

Economical analysis for a new equipment:*Initial cost of the equipment is $50,000 depreciated SL for 3 years >> D = $16,667*Will generate gross income of $30,000 and expenses of $10,000 (taxable income $20,000) for 3 years*The marginal tax rate is 34% (i.e. 90,000 current taxable income)Year Cash flow (wrong) Taxable income Tax Net income 1 20000-50000 20000-16667 1133 22002 20000 20000-16667  1133 22003 20000 20000-16667 1133 2200 Year Before tax Taxable Tax after tax

cash flow Dep. income . 34% cash flow0 -50000 -500001 20000 16667 20000-16667 1133 188672 20000 16667 20000-16667 1133 188673 20000 16667 20000-16667 1133 18867

EGR 403, Jan 00

Effect of tax on loan:

Loan amount = $2,000, i = 10%, Uniform payments

End of Amount of Interest Principal Remainingyear payment portion portion principal

1 527.6 200 327.6 1672.42 527.6 167.24 360.36 1312.043 527.6 131.2 396.4 915.644 527.6 91.56 436.04 479.65 527.6 47.96 479.64 0

Effect of tax on loan:Loan payment is not an expense, but interest portion is.

End of Loan Interest Reduction in Cash flowyear payment portion tax t=10% after tax .1 527.6 200 20 527.6-20 = 507.62 527.6 167.24 3 527.6 131.2 4 527.6 91.565 527.6 47.96

EGR 403, Jan 00

Income Tax Incremental (Marginal) tax rate

Combined Federal and State Income Taxes: Combined incremental tax rate = incremental State tax rate + (incremental Federal tax rate)*(1 - incremental State tax rate)

Capital Gains and LossesCapital {gain or loss} = Selling price - Book value

EGR 403, Jan 99

Replacement Analysis

Defender and Challenger

Shall we replace the defender now, or shall wekeep it for one or more additional years?

Minimum cost life: number of years at which theEUAC of ownership is minimized.

Marginal costs: year-by-year costs

EGR 403, Jan 99