CHAPTER 7

DEPRECIATION AND INCOME TAXES

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DEPRECIATION
Decrease

in value of physical properties with passage of time and use Accounting concept establishing annual deduction against before-tax income - to reflect effect of time and use on assets value in
firms financial statements

- to match yearly fraction of value used by asset in

production of income over assets economic life

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PROPERTY IS DEPRECIABLE IF IT MUST :

be

used in business or held to produce income have a determinable useful life which is longer than one year wear out, decay, get used up, become obsolete, or lose value from natural causes not be inventory, stock in trade, or investment property

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DEPRECIABLE PROPERTY
TANGIBLE

- can be seen or touched personal property - includes assets such as machinery,

vehicles, equipment, furniture, etc... real property is land, anything build on, growing on, or attached to land
(However, since land does not have a determinable life itself, it is not depreciable)

INTANGIBLE

- personal property, such as copyright, patent or franchise

(we will not discuss this concept because engineering projects rarely include this class of property)
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WHEN DEPRECIATION STARTS AND STOPS

Depreciation

starts when property is placed in service for use in business or for production of income Property is considered in service when ready and available for specific use, even if not actually used yet Depreciation stops when cost of placing it in service is removed or it is retired from service

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Causes in declining values

The decreasing worth may be attributed to any of the following conditions:
1.

2.

3.

4.

Physical depreciation. The everyday wear and tear of operation gradually lessens the physical ability of an asset to perform its intended function. Functional depreciation. Demand made on asset may increase beyond its capacity to produce. On the other extreme, the demand for services may cease to exist, such as with a machine that produces a product no longer in demand. Technological depreciation. Newly developed means of accomplishing a function may make the present means uneconomical. Old designs become obsolete. Sudden failure. Sudden loss in value that include accident and misuse.
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DEPRECIATION CONCEPTS
Basis,

or cost basis --- also called unadjusted cost --- initial cost of acquiring an asset, plus sales tax, transportation, and normal costs of making asset serviceable
[total cost of the machine should be viewed as an asset and used to calculate depreciation deductions]

Adjusted

cost basis --- allowable adjustment (increase or decrease) to original cost basis.
[any improvement to capital asset will increase the original cost. Any casualty of loss to the asset will decrease its original cost]

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DEPRECIATION CONCEPTS
Book

Value (BV) --- Worth of depreciable property as shown on accounting records --- Original cost basis of property, including adjustments, less allowable depletion or depreciation deductions --- Represents amount of capital remaining invested in property and must be recovered in future through accounting
k

(Book Value)k= adjusted cost basis - (depreciation deduction)j

J=1

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DEPRECIATION CONCEPTS
Market

Value (MV) --- Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact --- approximates present value of what will be received through ownership of property, including time-value of money (or profit)

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DEPRECIATION CONCEPTS
Salvage

Value (SV) --- Estimated value of property at the end of useful life. --- expected selling price of property when asset can no longer

be used productively --- net salvage value is used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows to determine net salvage value --- with classical methods of depreciation, estimated salvage value is established and used in the calculation of depreciation.
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DEPRECIATION CONCEPTS
Useful Life -- Expected (estimated) period of Useful Life -- Expected (estimated) period of

time property will be used in trade or time property will be used in trade or business or to produce income; sometimes business or to produce income; sometimes referred to as depreciable life.. referred to as depreciable life

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DEPRECIATION CONCEPTS
The following terms are used in the classical (historical) depreciation method equations:
N = depreciable life of the asset in years B = cost basis, including allowable adjustments d k = annual depreciation deduction in year k (1< k <N) d k* = cumulative depreciation through year k BV k = book value at the end of year k BV N = book value at the end of the depreciable (useful) life SV N = salvage value at the end of year N R = the ratio of depreciation in any one year to the BV at the beginning of the year
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STRAIGHT-LINE (SL) METHOD

Simplest depreciation method Assumes constant amount is depreciated each year over depreciable (useful) life

d k = ( B - SVN ) / N d k* = kdk for 1 < k < N BVk = B - d k*

B = cost basis, including allowable adjustments

This method requires an estimate of the final SV ( also the final book SEMESTER JULY 2010 13 value at the end of year N )

UNITS-OF-PRODUCTION METHOD
Decrease

in value of property is NOT a function of time Decrease in value is a function of use Method results in cost basis (minus final SV) being allocated equally over the estimated number of units produced during useful life of asset. Depreciation per unit of production = ( B - SVN ) / ( Estimated lifetime production in units )
B = cost basis including allowable adjustments
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Introduction to Income Taxes

We

will discuss how income taxes affect a projects estimated cash flows. WHY
Income taxes may represent a major cash outflow that should be considered together with other cash inflows and outflows in assessing the overall economic profitability of that project.

Income

taxes paid are just another type of expense. Income taxes saved (through depreciation) are identical to other kind of savings such as savings in maintenance expenses.
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TYPES OF TAXES 1. Income taxes - assessed as a function of gross revenues minus allowable deductions 2. Property taxes - assessed as a function of value of property owned - independent of income or profit of firm 3. Sales taxes - assessed on the basis of purchases of goods and services - independent of gross income or profits - relevant to engineering studies. They add to the cost of items that we purchased. 4. Excise taxes - assessed on sale of certain nonessential goods and services - independent of business income or profit - Although, it is charged to the manufacturer, a portion of the cost ultimately passed on to consumer.
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BEFORE-TAX MARR
( Before Tax MARR ) [ ( 1- effective income tax rate ) ]

= After Tax MARR

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BEFORE-TAX and AFTER-TAX MARR

( Before Tax MARR ) [ ( 1- effective income tax rate ) ] =

After Tax MARR

Before-tax MARR =

After-tax MARR -------------------------------( 1 - effective tax rate )

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CALCULATING TAXABLE INCOME - NET INCOME BEFORE TAXES ( NIBT ) Calculate

Gross Income Gross Profits ( revenues from sales - cost of goods sold ) + income from dividends, interest, rent, royalties, and gains (losses) from sale or exchange of capital assets Deduct operating expenses to conduct business that include interest but exclude capital investments Deduct depreciation (this is as a means of recovering capital investment). taxable income = gross income - all expenses depreciation (NIBT)
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NET INCOME AFTER TAXES (NIAT)

The

taxable income (NIBT), subtracts income taxes, the remainder is called NIAT Net Income After Taxes = NIBT - income taxes NIAT = NIBT - income taxes

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GAIN (LOSS) ON DISPOSAL OF A DEPRECIABLE TANGIBLE ASSET

[ GAIN (LOSS) ON DISPOSAL ] N = MVN - BVN

When a depreciable asset is sold, the MV is seldom equals to its BV. When sales results in a gain, it is depreciation recapture.

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Example: An equipment is sold during the current tax year for $78,600. Accounting record shows that its cost basis, B, is $190,000 and the accumulated depreciation is $139,200. Effective income tax rate is 40%.
Gain

(loss) on disposal: BV at time of sales = $190,000 $139,200 = $50,800 Gain (loss) on disposal = $78,600 $50,800 = $27,800 [this is gain] Tax liability: Tax owned on this gain = - 0.40 ($27,800) = - $11,120
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BEFORE-TAX ECONOMIC ANALYSIS

NIBT = ( Rk Ek- dk ) = taxable income Tk = - t ( Rk Ek dk )
Rk = revenues (or savings from the project: cash inflow from project during period k Ek = cash outflows during year k for deductible expenses and interest dk = sum of all book costs during year k, such as depreciation t = effective income tax rate on ordinary income; assumed to remain constant during the study period Tk= income taxes paid during year k
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Table to facilitate computation of ATCF

(A) Year BTCF (B) Depreciation (C)=(A)-(B) NIBT (D)=-t(C) C/flow for income tax
-t(Rk Ek dk)

(E)=(A)+(D) ATCF

Rk Ek

dk

Rk Ek dk

(1-t)(Rk Ek)+tdk

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Example:
Revenue from a project is $10,000 during a tax year. Expenses are $4,000, and depreciation deductions for income tax purposes are $2,000. Find (a) ATCF when t = 0.40 (b) NIAT (a)
(A) Year 1 BTCF $6,000 (B) Depreciation $2,000 (C)=(A)-(B) NIBT $4,000 (D)=-t(C) C/flow for income tax - $1,600 (E)=(A)+(D) ATCF $4,400

(b) NIAT = NIBT - income taxes = $4,000 - $1,600 = $2,400 Or, NIAT = ATCF depreciation = $4,400 - $2,000 = $2,400 ( Rk Ek- dk ) JULY 2010 SEMESTER

$10,000 - $4,000
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Example:
Consider the following proposed capital investment. Determine (a) Year-by-year ATCF (b) After-tax AW Proposed capital investment Salvage value (end of 4 years) Annual expenses per year Gross revenues per year Depreciation method Useful life Effective income tax rate (t) After-tax MARR (i) = - $84,000 = $0 = - $30,000 = $70,000 = Straight line = 4 years = 28% = 12%

Yearly depreciation = $84,000/4 = $21,000 Annual (Rk - Ek) = $70,000-$30,000 = $40,000

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EOY

BTCF

Depreciation

Taxable Income 19,000 19,000 19,000 19,000

Income Taxes - 5,320 - 5,320 - 5,320 - 5,320

ATCF

0 1 2 3 4

- 84,000 40,000 40,000 40,000 40,000

21,000 21,000 21,000 21,000

-84,000 34,680 34,680 34,680 34,680

(b) The annual equivalent worth, AW of the ATCF equals - $84,000( A/P, 12%, 4) + 34,680 = $7,027

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Depreciation: Straight-line (SL) Method

Discussion Q7-10
A company purchased a machine for $15,000. It paid sales tax and shipping costs of $1,000 and installation costs amounting to $1,200. The company had depreciated the machine on a SL basis, using an estimated life of five (5) years and $1,000 salvage value (SV). Unfortunately, at the end of 3 years, the company had no further use for the machine, so it spent $500 to have the machine dismantled and was able to sell the machine for $1,500. (a) What is the cost basis for the machine? (b) Determine the yearly depreciation. (c) Calculate the book value (BV) of the machine at the end of the third year (EOY 3). (d) By what amount ($) did the depreciation deductions fail to cover the actual depreciation?
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Depreciation: Units-of-Production Method

Discussion Q7-15 A special purpose machine is to be depreciated as a linear function of use (units-of-production method). It costs $25,000 and is expected to produce 100,000 units and then be sold for $5,000. Up to the end of third year, it had produced 60,000 units, and during the fourth year it produced 10,000 units. (a) What is the depreciation per unit of production? (b) What is the depreciation deduction for the fourth year? (c) Determine the cumulative depreciation through year four, dk*. (d) Calculate the book value (BV) at the end of the fourth year.
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After-Tax Economic Analysis

Discussion:
A company purchased a machine for $15,000. It paid sales tax and shipping costs of $1,000 and installation costs amounting to $1,200. This machine is expected to increase the production capacity and generate yearly net revenue of $8,000. The company had depreciated the machine on a SL basis, using an estimated life of five (5) years and $1,000 salvage value (SV). Unfortunately, at the end of 3 years, the company had no further use for the machine, so it spent $500 to have the machine dismantled and was able to sell the machine for $1,500. Consider effective income-tax rate of 40%. (a) (b) (c) Based on the above information, what is the gain (loss) on disposal? Determine the tax liability (credit) resulting from this sale. Determine the after-tax cash flow.
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