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ENGR 3360U Winter 2014

Unit 11
Cash Flow and Depreciation
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 11 Cash Flow and Depreciation

Change Record
2014-I-01 Initial Creation

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Course Outline

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0 Macro-Micro Eco
2 Eng Estimation
3-4 Interest and Equivalence
5 Present Worth
6 Annual Cash Flow
7 Rate of Return
8 Choosing the Best Alternative
9 Other Analyses
10 Risk and Uncertainty

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11 Depreciation
12 After-Tax Cash Flow
13 Replacement Analysis
14 Inflation
15 MARR Selection
16 Public Sector Issues
17 Accounting
18 Business Plans
19 Summary

Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Unit 11 Road Map

11-4

11.1 Income and Depreciation


11.2 Types of depreciable property
11.3 Depreciation methods
11.4 Capital Cost Allowance
11.5 Natural Resource Allowances

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

11.1 Income
The measure of a businesss success is its annual
profit or loss.
More simply:
Income = Revenue Costs to obtain revenue

Revenue is money coming in and costs are money


going out to obtain the resources to generate revenue.
There is, however, a group of items called physical
assets which are obtained and typically lose value
over time.
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Unit 11 Cash Flow and Depreciation

Depreciation

Defined as:

Decrease in value (three distinct possibilities):


1)
2)
3)

A machine may decrease in value because it is


deteriorating or wearing out.
Depreciation is also caused by obsolescence.

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Decline in market value


Decline in value to an owner
Systematic allocation of the cost of an asset over its
depreciable life (accountants definition)

When it is no longer useful or needed

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Depreciation versus Expenses


Expenses are consumed over the normal

course of business and over a short period of


time.

Labour, materials, insurance, etc.

In contrast, capital assets are not fully

written off when they occur.


They are depreciated over an extended
period of time because they have a
depreciable life.

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Buildings, large machines, vehicles, computers,


etc.

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Depreciation
Depreciation is a non-cash cost (no actual exchange of
dollars).
Depreciation is a way to claim business expenses over
time.
To be depreciable, assets must:

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Be used for business purposes to produce income


Have a useful life that can be determined and that is longer
than one year
Be an asset that decays, gets used up, wears out, becomes
obsolete, or loses value to the owner from natural causes

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

11.2 Types of Property


Tangible Property

Can be seen, touched, and felt

Real Property

Land, buildings, and all things growing on, built upon,


constructed on, or attached to the land

Personal Property

Equipment, furnishings, vehicles, and any other tangible


property that is NOT real property

Intangible Property

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Value to the owner but cannot be seen or touched; patents,


copyrights, trademarks, trade names, and franchises

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Depreciation
Exceptions to depreciation:

Land is never depreciated (never wears out)


Leased property
Factory inventory

Cost Basis

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Total cost of acquiring an asset that is an


expense over the life of the asset

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Unit 11 Cash Flow and Depreciation

11.3 Depreciation Methods


Book Value
Book value = Cost basis Depreciation charges made to date

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Unit 11 Cash Flow and Depreciation

Depreciation Methods
Straight Line Depreciation
Annual depreciation charge = d1=(B-S)/N

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B = cost basis, S = salvage value, N = depreciable life

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Example
Cost of asset $900
Life
5 years
Salvage
$70
Annual dep = (900-70)/5 = 166
Value = 900 n(166)

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Unit 11 Cash Flow and Depreciation

Straight Line
1 d1 = (900-70)/5 = 166 BV = 900-166=734
2 d2 = 2(900-70)/5 = 332 BV = 900-332=568

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Unit 11 Cash Flow and Depreciation

Depreciation Methods
Sum-of-Years-Digits Depreciation
N t 1
dt
(B S )
SOYD

dt= depreciation charge in any year t

N = number of years in depreciable life


SOYD = sum of years digits; N(N+1)/2
N=5; SOYD = 1+2+3+4+5 = 15
B = cost of the asset made ready for use
S = estimated salvage value
d1 = ((5-1+1)/15)(900-70) = 277

d2 = ((5-2+1)/15)(900-70) = 221
d3 = ((5-3+1)/15)(900-70) = 166
d4 = ((5-4+1)/15)(900-70) = 111
d5 = ((5-5+1)/15)(900-70) = 055

0.1-15

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Depreciation Methods
Declining Balance

applies a constant depreciation rate (D%)


Ignores salvage value
dn=DB(1-D)n-1=DBVn-1

Double Declining Balance


dt=(2/N)(Book valuet-1)

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Unit 11 Cash Flow and Depreciation

Declining Balance (D=30%)


1 d1 = 900(.30) = 270 BV = 900-270 = 630
2 d2 = 630(.30) = 189 BV = 900-459 = 441
3 d3 = 441(.30) =132 BV = 900-591 = 309
4 d4 = 309(.30) =92.7 BV = 900-683.7 = 216.3
5 d5 =216.3(.30) =65 BV = 900-749 = 151
Note: does not depreciate enough. Readjust

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Unit 11 Cash Flow and Depreciation

Declining Balance (D=40%)


1 d1 = 900(.40) = 360 BV = 900-360 = 340
2 d2 = 340(.40) = 216 BV = 900-576 = 324
3 d3 = 324(.40) =130 BV = 900-706 = 194
4 d4 = 194(.40) = 78 BV = 900-784 = 116
5 d5 = 116(.40) =46 BV = 900-830 = 70

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Unit 11 Cash Flow and Depreciation

Double Declining (twice linear)


1 d1 = (900-70)(2/5)=332 BV=(900-70)-332 =498
2 d2 = (498)(2/5) = 199 BV = 830-531 = 299
3 d3 = (299)(2/5) = 120 BV = 830-651 = 179
4 d4 = (179)(2/5) = 72 BV = 830-723 = 107
5 d5 = (107)(2/5) = 43 BV = 830-766 = 64

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Unit 11 Cash Flow and Depreciation

Depreciation Methods
Unit-of-Production Depreciation

Based on use, not time.


UOP depreciation in any year =
(Production for year/Total lifetime production) (BS)

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Unit 11 Cash Flow and Depreciation

Example
B=900 S=70
Year 1 4K 2 8K 3 16K 4 8K 5 4K = 40K
Dep 1 = (900-70)*4K/40K = 83
Dep 2 = 166
Dep 3 = 332
Dep 4 = 166
Dep 5 = 83
Total = 830
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Unit 11 Cash Flow and Depreciation

Capital Cost Allowance


Canada has legislation on how assets are
depreciated.
There are different rates for different types of
assets.
The maximum capital cost allowance a
company can take in one year is what would be
sufficient to reduce taxable income to zero.
Generally, only 50% of a given rate is allowed
in the first year of depreciation.
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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Typical CCA Rates and Classes


08
09
10
12
45

Property not included in named classes


Aircraft, including their furniture and spare parts
Automobiles, personal computers, systems software
Chinaware, uniforms, dies, computer software
General purpose computers

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20%
25%
30%
100%
45%

Dr. J.M. Bennett ENGR


2014-I-01
3360

Unit 11 Cash Flow and Depreciation

Calculations
Straight-forward
CCA is an optional tax deduction
Based on the UCC that year
Land cannot be depreciated
50% rule applies
If the tax year is not a full year, pro-rate

Dr.

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Unit 11 Cash Flow and Depreciation

Example
On January 1, Oshawa Bearing Services
purchases a machine for $100,000
belonging to Class 8 (20%). Determine the
depreciation schedule for the first 3 years.
Dec 31, year 1
Dec 31, year 2
Dec 31, year 3

Dr.

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CCA
10000
18000
14400

UCC
90000
72000
57600

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Unit 11 Cash Flow and Depreciation

Recapture
If when the property is sold, the UCC is
negative, too much has been depreciated.
Tax man cometh! Will claw-back the
excess.

Dr.

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Unit 11 Cash Flow and Depreciation

Example continued
Oshawa Bearing buys a second machine in Year 4 for
$150,000. In Year 6, it sells the first for $60,000.
Next year it sells the second machine for
$100,000. Do the tax calculations.

Dr.

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Unit 11 Cash Flow and Depreciation

Example continued
Dec 31, year 1
Dec 31, year 2
Dec 31, year 3
Dec 31, year 4
Dec 31, year 5
Dec 31, year 6
Recapture

Dr.

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CCA
100000
18000
14400
150000 11520+15000
( -60000)
24216
-100000

UCC
90000
72000
57600
181080
96864
-3136
-3136

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Unit 11 Cash Flow and Depreciation

Depreciation and Asset Disposal


Taxes-owed changes based on different
factors with respect to disposal:

Recaptured CCA

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Occurs when an asset is sold for more than the book


value

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Unit 11 Cash Flow and Depreciation

Depreciation and Asset Disposal, contd.

Loss on disposal

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Occurs when the market value is less than the book


value
Did not claim enough depreciation expense

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Unit 11 Cash Flow and Depreciation

Depreciation and Asset Disposal, contd.

Capital Gains

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Occur when the asset is sold for more than its


original cost
The excess over the original cost is a Capital
Gain.

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

11.5 Natural Resources Allowances


Depletion

The consumption of exhaustible natural resources


Provinces own their resources and subsequently the rules
are different across the country.
Two standard methods of calculating depletion:

Percentage Depletion

A certain percentage of the propertys gross income


during the year

Cost Depletion

Computed like unit-of-production depreciation


Calculation uses

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Property cost
Estimated number of recoverable units
Salvage value of the property

Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Depletion Methods
Depreciation is applied to
assets that can be
replaced.
Depletion applies to
resources that are not
easily replaced, like:
Timber,
Mineral deposits,
Oil and gas,
etc.

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Cost Depletion

Also called factor depletion


Based upon the level of activity
or usage;
Time is not involved.

first cost
pt
resource capacity
pt cos t depletion factor for year t

Percentage Depletion
Applies a constant, stated percentage
of the resource's gross income
provided it does not exceed 50% of
the firms current taxable income.

Dr. J.M. Bennett ENGR 3360

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Unit 11 Cash Flow and Depreciation

Depletion: Cost Depletion


First, the cost basis of the resource
is determined first cost or
investment cost.
Second one must estimate the
amount of the resource that is
available for extraction.
Termed: Resource Capacity.
It is an estimated value since it is
impossible to predict exactly the
true resource capacity!

Then, cost depletion factor pt for


year t is calculated

Let t denote the year


pt denotes the
depletion factor for
year t
Then, pt is defined as:

initial cost
pt
resource capacity
Percentage depletion amount =
Percentage x gross income from
property

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Unit 11 Cash Flow and Depreciation

Depletion: Important Issue


Major Point for depletion:
There must be a reasonable estimate of the
amount of the resource that is being extracted.

For firms engaged in extraction activities


the process of resource estimation is an
important activity and requires expert
analysis.

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Unit 11 Cash Flow and Depreciation

Percentage Depletion
A constant stated percentage of the resources gross
income may be depleted each year so long as:
The calculated depletion amount does not exceed 50% of the
firms taxable income
Allowable depletions rates are published by CRA

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Dr. J.M. Bennett ENGR 3360

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Unit 11 Cash Flow and Depreciation

Example
MacMillan-Bloedel has negotiated the rights to cut timber on an acreage
for $700,000. An estimated 350 million board feet of lumber are
harvestable.
a) Determine the depletion allowance for the first 2 years, if 15 million
and 22 million board feet are removed.
b) After 2 years, the total recoverable board feet was re-estimated to be
450 million from the time the rights were first purchased. Compute
the new cost depletion factor for years 3 and later.

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Unit 11 Cash Flow and Depreciation

Solution
a)
b)

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pt = 700000/350 = $2000 per million BF. Thus first year depletion is


2000(15000000) = 30000.
After 2 years, 74000 has been remove. Value is now 626000. New
estimate is 450-11-22 = 415. Therefore
pt = 626000/415 = $1516 per MBF

Dr. J.M. Bennett ENGR 3360

2014-I-01

Unit 11 Cash Flow and Depreciation

Summary
Depreciation: Expense of an asset that is

calculated over the depreciable life of the


asset.
There are a number of types of depreciable
assets.
There are also a number of depreciation
methods.
In Canada, legislation provides the rules for
depreciation of assets. Called:

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Capital Cost Allowance

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Dr. J.M. Bennett ENGR 3360

Unit 11 Cash Flow and Depreciation

Summary, contd.
Disposed-of assets might not be disposed
of at the book value of an asset.

Adjustments must be made to compensate for


this discrepancy.

Natural Resources that are exhaustible use


Depletion methods.
Provinces own their resources and
therefore different rules regarding depletion
exist across the country.
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Dr. J.M. Bennett ENGR 3360

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