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Copyright 2009 by Pearson Education, Inc.
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Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Engineering Economy
Depreciation and Income Taxes
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
The objective of this report is toexplain how depreciation affects
income taxes, and how incometaxes affect economic decision
making.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Income taxes usually represent a
significant cash outflow. In this
chapter we describe how after tax
liabilities and after-tax cash flowsresult in the after-tax cash flow
(ATCF)procedure. Depreciation
is an important element in
finding after-tax cash flows.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Depreciation is the decrease in value of
physical properties with the passage oftime.
It is an accounting concept, a non-cash cost,that establishes an annual deduction against
before-tax income.
It is intended to approximate the yearly
fraction of an assets value used in the
production of income.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Property is depreciable if
it is used in business or held to produceincome.
it has a determinable useful life, longer than
one year.
it is something that wears out, decays, getsused up, becomes obsolete, or loses value
from natural causes. it is not inventory, stock in trade, or
investment property.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Depreciable property is
tangible (can be seen or touched; personal
or real) or intangible (such as copyrights,
patents, or franchises).
depreciated, according to a depreciation
schedule, when it is put in service (when it
is ready and available for its specific use).
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Straight line (SL): constant amount of
depreciation each year over thedepreciable life of the asset.
N= depreciable life
B = cost basis dk= depreciaton in k
BVk= book value at
end ofk
SVN
= salvage value
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Declining-balance (DB): a constant-
percentage of the remaining BV isdepreciated each year.
The constant percentage is determined by R,
where R = 2/Nwhen 200% declining balance is
being used, R = 1.5/Nwhen 150% declining
balance is being used.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
The units-of-production method can be
used when the decrease in value of theassset is mostly a function of use, instead
of time. The cost basis is allocated
equally over the number of unitsproduced over the assets life. The
depreciation per unit of production is
found from the formula below.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
The Modified Accelerated CostRecoverySystem (MACRS) is the principle
method for computing depreciation for
property in engineering projects. Itconsists of two systems, the main system
called the General Depreciation System
(GDS) and theAlternative DepreciationSystem (ADS).
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
When an asset is depreciated using
MACRS, the following information isneeded to calculate deductions.
Cost basis, B
Date the property was placed into service
The property class and recovery period
The MACRS depreciation method (GDS or
ADS).
The time convention that applies (half year)
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth EditionBy Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Using MACRS is easy!
1. Determine the assets recovery period
2. Use the appropriate column that matches the
recovery period to find the recovery rate, rk, andcompute the depreciation for each year as
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
There are many different types of taxes.
Income taxes are assessed as a function of grossrevenues minus allowable expenses.
Property taxes are assessed as a function of the
value of property owned. Sales taxes are assessed on the basis of purchase
of goods or services.
Excise taxes are federal taxes assessed as a
function of the sale of certain goods or servicesoften considered nonnecessities.
We will focus on income taxes.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Taking taxes into account changes
our expectations of returns on
projects, so our MARR (after-tax) is
lower.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
The after-tax MARR should be at least
the tax-adjusted weighted average cost ofcapital (WACC).
P = fraction of a firms pool of capital borrowed
from lenders
t = effective income tax rate as a decimal
ib
= before-tax interest paid on borrowed capital
ea = after-tax cost of equity capital
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Depreciation is not a cash flow, but it
affects a corporations taxable income, andtherefore the taxes a corporation pays.
Taxable income = gross income
all expenses except capital invest.
depreciation deductions.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Federal taxes are calculated using a set
of income brackets. each applying adifferent tax rate on the marginal value
of income. State taxes vary widely.
Tax rates are found in Table below.
Corporations need to know theireffective tax rate,
which is a combination of federal and state taxes
according to either formula below.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
The disposal of a depreciable asset can
result in a gain or loss based on the saleprice (market value) and the current
book value
A gain is often referred to as depreciation recapture,
and it is generally taxed as the same as ordinaryincome. A loss is a capital loss. An asset sold for
more than its cost basis results in a capital gain.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
After-tax economic analysis is
generally the same as before-tax
analysis, just using after-tax cash
flows (ATCF) instead of before-tax cash flows (BTCF). The
analysis is conducted using the
after-tax MARR.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Cash flows are typically determined for
each year using the notation below.
Rk = revenues (and savings) from the projectduring period k
Ek = cash outflows during kfor deductibleexpensesdk = sum of all noncash, or book, costs
during k, such as depreciationt = effective income tax rate on ordinary
incomeTk = income tax consequence during yeark
ATCFk = ATCF from the project during yeark
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Some important cash flow formulas.
Taxable income
Ordinary income tax consequences
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Acme purchased a pump for $250,000 and
expended $20,000 for shipping andinstallation. The addition of this pump will
result in an increase in revenue of $80,000,
with associated increased expenses of$10,000, each year. The pump has a GDS
recovery period of five years, and Acmes
effective tax rate is 41%. What is the ATCF
for this project for the fourth year of serviceof the asset?
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Economic value added, EVA, is anestimate of the profit-earningpotentialof
proposed capital investments in
engineering projects. It is the differencebetween a companys adjusted net
operating profit after taxes (NOPAT) in
a particular year and its after-tax cost ofcapital during that year.
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
where,
and
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Copyright 2009 by Pearson Education, Inc.
Upper Saddle River, New Jersey 07458All rights reserved.
Engineering Economy, Fourteenth Edition
By Will iam G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
For Acme, what is the EVA for year 4 if
their after-tax MARR is 8%?