Depreciation

IE463 Chapter 5
DEPRECIATION AND INCOME TAXES

Depreciation is the decrease in the value of physical properties with passage of time Because, depreciation is a non-cash cost that affects income taxes we must consider depreciation properly, when making After-Tax Engineering Economy studies

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Depreciable Property

Basic Terminology

It is a property for depreciation is allowed under governmental income tax laws and regulations In general, property is depreciable if it meets the following basic requirements:
It

must be used in business or held to produce income. It must have a determinable useful life, and the life must be longer than one year. It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.
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Depreciation = an annual non-cash charge against income. It represents an estimate of the dollar cost of fixed assets used in the production of a good or service. Cost Basis (B) = actual cash cost plus book value of trade-in (if any) plus costs of making asset serviceable (e.g., installation). Book Value (BVk) = value of asset as shown on the accounting records. Represents amount of money still invested in the property. BVk = book value at EOY k SVN = estimated salvage value in year N (used in depreciation calculations where applicable) MVN = market (resale) value at EOY N from the disposal of an asset
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STRAIGHT-LINE (SL) METHOD

DECLINING BALANCE (DB) METHOD

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A constant amount is depreciated each year over the asset's life. N = depreciable life of the asset in years. dk = annual depreciation deduction in year k dk = (B - SVN ) / N for k = 1, 2, ..., N dk* = cumulative depreciation through year k. dk* = k x dk BVk = B - dk *

Annual depreciation is a constant percentage of the asset's value at the BOY R = 2/N 200% declining balance R = 1.5/N 150% declining balance d1 = B x R dk = B(1-R)k-1 (R) = BVk-1 (R) dk* = B[1 - (1 - R)k ] BVk = B(1 - R)k BVN = B(1 - R)N
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SL and DB Example

Cost basis:

The La Salle Bus Company has decided to purchase a new bus for $85,000, with a trade-in of their old bus. The old bus has a trade-in value of $10,000. The new bus will be kept for 10 years before being sold. Its estimated salvage value at that time is expected to be $5,000. Compute the following quantities using (a) the straight-line method, (b) the 200% declining balance method

B = $10,000 + $85,000 = $95,000

trade-in value cash-cost

SV10

Deduction amounts are fixed for SL:

dk 95,000 - 5,000 $9,000 for k 1 to10 10 2 10
N

Deduction ratios are fixed for DB:

200% DB

depreciation deduction in the first year and the fourth year cumulative depreciation through year four book value at the end of the fourth year
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0.2 , thus,(dk
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0.2 BVk -1 )
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Straight Line Method (k = 1 to 4)

EOY, k 0 1 2 3 4 dk 0 9,000 9,000 9,000 9,000 BVk 95,000 86,000 77,000 68,000 59,000

Straight Line Method (k = 5 to 10)

EOY, k 5 6 7 8 9 10 dk 9,000 9,000 9,000 9,000 9,000 9,000 BVk 50,000 41,000 32,000 23,000 14,000 5,000 = 59,000 9,000 = 50,000 9,000 = 41,000 9,000 = 32,000 9,000 = 23,000 9,000 = 14,000 9,000

= 95,000 9,000 = 86,000 9,000 = 77,000 9,000 = 68,000 9,000 BV4 = 95,000 36,000
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d4 = d1 d4* = 4 x 9000 = 36,000

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SV10 = B N x dk
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200% Declining Balance Method (k = 1 to 4)

EOY, k 0 1 2 3 4 dk 0 19,000 15,200 12,160 9,728 d1 = BV0 x R = B x 0.2 = 95,000 x 0.2 = 19,000 BVk 95,000 76,000 60,800 BV1 = BV0 d1 = B d1 48,640 = 95,000 19,000 38,912 BV4 = B d4* d4 = 48,640 x 0.2
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200% Declining Balance Method (k = 5 to 10)

EOY, k 5 6 7 8 9 10 dk 7,782 6,226 4,981 3,985 3,188 2,550 BVk 31,130 24,904 19,923 15,938 12,750 10,200 BV10 = B d10* = BV9 d10
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d4* = 19,000 + ... + 9,728 = 56,088

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SL vs. DB

Consideration of Income Taxes in EE

Income tax represents a significant cash outflow that we cannot ignore
Notation: Rk = gross revenues in year k Ek = operating expenses in year k plus interest paid on borrowed capital dk = depreciation allowance for year k t = effective income tax rate used for computing income taxes Tk = income tax liability for year k
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General Tax Procedure

BTCF = Before tax cash flow = R E NIBT = Net income before tax = R E d T = tax liability = t ( NIBT ) = t (R E d) NIAT = Net income after tax = NIBT T = (R E d) t (R E d) = (1 t)(R E d) ATCF = After tax cash flow = NIAT + d ATCF = BTCF t (R E d)

General Tax Procedure - Example

You invested $113,028 on an asset with the depreciable life of 10 years. You can earn $30,000 per year from this investment for 10 years. Asset has a negligible or zero MV at the end of its useful life. Published income tax rate is 40% on annual taxable income (NIBT). Use after-tax MARR of 15% per year, and straight line depreciation method. NIBT? NIAT? ATCF? Is it profitable investment after taxes?
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a) b) c) d)

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Solution to (a), (b) and (c)

Solution to part (d)

AW (15%) = ATCF 113,028 (A/P, 15%, 10) = 22,521 22,521 = $0

d = 113,028 / 10 = $11,303 (depreciation amount) (+) Net income 30,000 (-) Deprecation 11,303 (a) NIBT $18,697 (R E d) (-) Income Tax (0.4) 7,479 (b) NIAT $11,218 (1 t)(R E d) (+) Depreciation 11,303 (c) ATCF $22,521 (1 t)(R E d)+d

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Typical Before-Tax Cash Flow Diagram:

After-Tax Cash Flow Analysis

Typical After-Tax Cash Flow Diagram:

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After-tax MARR

ATCF Analysis Example

To perform an after-tax evaluation of a project's after-tax cash flows, we must use an after-tax MARR. After - tax MARR Before - tax MARR 1 - effective income tax rate, t
Example: Suppose the before-tax MARR = 20% and t = 40%. What is the approximate after-tax MARR?

MARR BT

MARR AT 1- t

MARR AT 0.2 (1 - 0.4) 0.12

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Investment $10,000 Net Annual Receipts $4,000/yr Study Period 4 years Market Value at EOY 4 $5,000 After-tax MARR 15% Effective income tax rate 40% Depreciable recovery period 5 years Is this a worthwhile investment after taxes? Use Straight Line Method for depreciation.

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Step 1: Find depreciation amounts for the study period of 4 years:

dk 10,000 - 0 5 $2,000 for k 1 to 5
dk --2000 2000 2000 2000
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Step 2: Determine the ATCF with tax rate of 40%:

EOY, k BTCFk - 10,000 4000 4000 4000 4000 5000 2000 2000 2000 2000 2000 2000 2000 2000 3000 -800 -800 -800 -800 -1200 dk TIk Tk (t = 0.4) ATCFk - 10,000 3200 3200 3200 3200 3800
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EOY, k 0 1 2 3 4

BVk 10000 8000 6000 4000 2000

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0 1 2 3 4a 4b

MV4 BV4 = 5000 2000

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Step 3: Use the ATCF to evaluate this investment @ MARR = 15%:

After-tax cash flow diagram:

Non-depreciable asset - Example

PW(15%) = 10,000 + 3,200 (P/A, 15%, 3) + 7,000 (P/F, 15%, 4) = + $1,309

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Construction cost of the facility $600,000 Purchasing cost of land $550,000 Annual gross income $230,000 Operating expenses per year $30,000 Facility will be depreciated for 5 years, using 200% DB MARRAT 12% Tax rate 40% Is the investment worthwhile after taxes for the study period of 5 years? Note: Land will be kept after the five-year operation! Facility has a market value of zero @EOY5
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200% DB
EOY, k 0 1 2 3 4 5 dk --240,000 144,000 86,400 51,840 31,104

R = 2/5 = 0.4
BVk 600,000 360,000 216,000 129,600 77,760 46,656
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ATCF analysis with t = - 0.4

EOY BTCF d TI Tax ATCF 0 -1,150,000 -1,150,000 1 200,000 240,000 -40,000 16,000 216,000 2 200,000 144,000 56,000 -22,400 177,600 3 200,000 86,400 113,600 -45,440 154,560 4 200,000 51,840 148,160 -59,264 140,736 5a 200,000 31,104 168,896 -67,558 132,442 - 46,656 18,662 568,662 5b 550,000 MV5 BV5 = 0 46,656 CHAPTER 5 550,000 + 18,662 28

cost basis for only depreciable asset 600,000 x 0.4 600,000 240,000 BV5 MV5 = 0
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ATCF analysis with MARRAT = 12%

EOY ATCF 0 -1,150,000 PW(12%) = - 1,150,000 1 216,000 + 216,000(P/F, 12%, 1) 2 177,600 + 177,600(P/F,12%, 2) 3 154,560 + 154,560(P/F, 12%, 3) 4 140,736 + 140,736(P/F, 12%, 4) 5a 132,442 + (132,442 + 568,662)(P/F, 12%, 5) 5b 568,662 = - $218,283 < 0 reject !
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Lease versus Purchase - Example

a) b)

Determine the more economic means of acquiring a copier in your business if you may either: purchase the copier for $5,000 with a probable resale value of $1,000 at the end of 5 years or rent the copier for an annual fee of $900 per year for 5 years with an initial deposit of $500 refundable upon returning the copier in good condition. If you own the copier, you will depreciate it by using the 150% DB method (class life of 5 years). All rental fees are deductible for income tax purposes. As the owner or lessee, you will pay all expenses associated with the operation of the copier. A deposit does not affect taxes when paid out or received back. Compare these alternatives by using the equivalent uniform annual cost method. The after-tax MARR is 10% per year, and the effective income tax rate is 40%.
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Option A Purchase Copier

EOY 0 1 2 3 4 5a 5b BTCF -5000 R=0.3 d 1500 1050 735 515 360 840 TI -1500 -1050 -735 -515 -360 160
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Option A Purchase Copier

EOY 0 1 2 3 4 5a 5b ATCF -5000 600 420 294 206 144 936 AW(10%) = [-5000 + 600(P/F,10%,1) +420(P/F,10%,2) +294(P/F,10%,3) +206(P/F,10%,4) +(144+936)(P/F,10%,5)](A/P,10%,5) = - 3075(A/P,10%,5) = - 811.185

t= -0.4 Tax 600 420 294 206 144 -64

1000

ATCF -5000 600 420 294 206 144 936

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Option B Rent (lease) Copier

EOY BTCF 0 -500 1 -900 2 -900 3 -900 4 -900 5a -900 5b 500 d TI -900 -900 -900 -900 -900 t = -0.4 Tax 360 360 360 360 360 ATCF -500 -540 -540 -540 -540 -540 500
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Option B Rent (lease) Copier

EOY 0 1 2 3 4 5a 5b ATCF -500 -540 -540 -540 -540 -540 500 AW (10%) = -500(A/P,10%,5) + 500(A/F,10%,5) 540 = - 590 Option B (lease) is the least cost alternative for having the coppier

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Before tax leasing cost?

Over what range of before-tax leasing costs would you choose the purchase option based on an after-tax analysis?

AW_lease =AW_purchase AW_lease = - 811.185 -500(A/P,10%,5) + 500 (A/F,10%,5) + (1 t) L say L = before tax leasing cost 0.6 L = 811.185 + 500(A/P,10%,5) 500 (A/F,10%,5) L = 1269 (if before tax leasing cost is greater than 1269, purchasing option will be preferred)
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