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Depreciation and Income Taxes
Chapter 9
Advanced Engineering Economy
Depreciation• Definition: Loss of value for a fixed asset• Example: You purchased a car worth $15,000 at the beginning of year 2000.
Dep
reciation
End of Year
Market
Value
Loss of
Value
0
1
2
3
4
5
$15,00010,000
8,0006,0005,0004,000
$5,0002,0002,0001,0001,000
Why Do We Consider Depreciation?
Gross Income -Expenses:(Cost of goods sold)(Depreciation)(operating expenses)
Taxable Income
- Income taxes
Net income (profit)
Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income.
Factors to Consider in Asset Depreciation
Depreciable life (how long?)
Salvage value (disposal value)
Cost basis (depreciation basis)
Method of depreciation (how?)
What Can Be Depreciated?
Assets used in business or held for production of income
Assets having a definite useful life and a life longer than one year
Assets that must wear out, become obsolete or lose value
A qualifying asset for depreciation must satisfy all of the three conditions above.
Cost Basis
Without Trade-In Allowance With Trade-In Allowance
Cost of a new hole-punching machine (Invoice price) $62,500+ Freight 725
+ Installation labor 2,150
+ Site preparation 3,500
Cost basis to use in depreciation calculation
$68,875
Cost of a new hole-punching machine (Invoice price) $62,500+ Freight 725
+ Installation labor 2,150
+ Site preparation 3,500
Cost basis to use in depreciation calculation
$68,875
Old hole-punching machine (book value) $4,000
Less: Trade-in allowance 5,000
Unrecognized gains $1,000
Cost of a new hole-punching machine $62,500
Less: Unrecognized gains (1,000)
Freight 725
Installation labor 2,150
Site preparation 3,500
Cost of machine (cost basis) $67,875
Old hole-punching machine (book value) $4,000
Less: Trade-in allowance 5,000
Unrecognized gains $1,000
Cost of a new hole-punching machine $62,500
Less: Unrecognized gains (1,000)
Freight 725
Installation labor 2,150
Site preparation 3,500
Cost of machine (cost basis) $67,875
Useful Life and Salvage Value
Useful life – Adopt the Asset Depreciation Ranges (ADR) published by the IRS. Salvage value – Asset’s estimated value at the end of its useful life. Every effort should be made to estimate a reasonable residual value of the asset, but if not possible, a 10% rule (10% of the initial value) could be adopted for depreciation purpose.
Types of Depreciation• Book Depreciation
– In reporting net income to Investors/stockholders– In pricing decision
• Tax Depreciation– In calculating income taxes for the IRS– In engineering economics, we use depreciation
in the context of tax depreciation
Book versus Tax Depreciation – An Overview
Component of Depreciation Book Depreciation Tax depreciation (MACRS)
Cost basis
Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc.
Same as for book depreciation
Salvage value
Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations.
Salvage value is zero for all depreciable assets
Component of Depreciation
Book Depreciation Tax depreciation (MACRS)
Depreciable life
Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs)
Eight recovery periods– 3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories.
Method of depreciation
Firms may select from the following: Straight-lineAccelerated methods (declining balance, double declining balance, and sum-of- years’ digits)Units-of-proportion
Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight-line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.
Book Depreciation Methods
• Purpose: Used to report net income to stockholders/investors
• Types of Depreciation Methods:– Straight-Line (SL) Method– Declining Balance Method– Unit Production Method
Straight – Line (SL) Method
• Principle A fixed asset as providing its service in a uniform fashion over its life
• Formula•Annual Depreciation
Dn = (I – S) / N, and constant for all n.•Book Value
Bn = I – n (D)where I = cost basis
S = Salvage valuen = depreciable life
Example: Straight-Line Method
D1
D2
D3
D4
D5
B1
B2B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0 1 2 3 4 5
Total depreciation at end of
lifen Dn Bn
0 10,0001 1,600 8,4002 1,600 6,8003 1,600 5,2004 1,600 3,6005 1,600 2,000
I = $10,000N = 5 YearsS = $2,000D = (I - S)/N
Annual Depreciation
Book Value
n
Declining Balance Method• Principle: A fixed asset as providing its service in a decreasing fashion• Formula
• Annual Depreciation
• Book Value
1 nn BD 1)1( n
nIB )1( where 0 << 2(1/N)
Note: if is chosen to be the upper bound, = 2(1/N),
we call it a 200% DDB or Double Declining Balance method.
Example: Declining Balance Method
D1
D2
D3D4
B1
B2
B3
B4 B5
$10,000
$8,000
$6,000
$4,000
$2,000
0 1 2 3 4 5
Total depreciation at end of
life
$778
Annual Depreciation
Book Value
n012345
Dn
$4,0002,4001,440
1600
Bn$10,00
06,0003,6002,16020002000
1
1
= $10,000
= 5 years
= $2000
=
= (1-
(1 )
n n
n
nn
I
N
S
D B
I
B I
n
ά =2(1/N) =2(1/5) =40%
Example: DB Switching to SL
• SL Dep. Rate = 1/5• (DDB rate) = (200%) (SL rate)
= 0.40
Asset: Invoice Price $9,000Freight 500Installation 500
Depreciation Base $10,000Salvage Value 0Depreciation 200% DBDepreciable life 5 years
n Depreciation
Book
Value
12345
10,000(0.4) = 4,000 6,000(0.4) = 2,400 3,600(0.4) = 1,440 2,160(0.4) = 864 1,296(0.4) = 518
$6,0003,6002,1601,296
778
n
Book
Depreciation Value
12345
4,000 $6,0006,000/4 = 1,500 < 2,400 3,6003,600/3 = 1,200 < 1,440 2,1602,160/2 = 1,080 > 864 1,0801,080/1 = 1,080 > 518 0
(a) Without switching (b) With switching to SL
Note: Without switching, we have not depreciated the entirecost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits.
Case 1: S = 0
Case 2: S = $2,000
End of Year Depreciation Book Value
1 0.4($10,000) = $4,000 $10,000 - $4,000 = $6,000
2 0.4(6,000) = 2,400 6,000 – 2,400 = 3,600
3 0.4(3,600) = 1,440 3,600 –1,440 = 2,160
4 0.4(2,160) = 864 > 160 2,160 – 160 = 2,000
5 0 2,000 – 0 = 2,000
Note: Tax law does not permit us to depreciate assets belowtheir salvage values.
Units-of-Production Method
• PrincipleService units will be consumed in a non
time-phased fashion
• Formula•Annual Depreciation
Dn = Service units consumed for yeartotal service units
(I - S)
Example
• Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles
• Solution:
30,000($55,000 $5,000)
250,000
3($50,000)
25
$6,000
Dep
Tax Depreciation
Tax Depreciation• Purpose: Used to compute income taxes for the IRS
•Assets placed in service prior to 1981
Use book depreciation methods (SL, DB)
•Assets placed in service from 1981 to 1986
Use Accelerated Cost Recovery System (ACRS) Table
•Assets placed in service after 1986
Use Modified Accelerated Cost Recovery System MACRS Table
Modified Accelerated Cost Recovery Systems (MACRS)
• Personal Property• Depreciation method based on DB method
switching to SL• Half-year convention• Zero salvage value
• Real Property• SL Method• Mid-month convention• Zero salvage value
MACRS Property Classifications
Recovery Period ADR Midpoint Class
Applicable Property
3-year Special tools for manufacture of plastic products, fabricated metal products, and
motor vehicles. 5-year Automobiles, light trucks, high-tech
equipment, equipment used for R&D, computerized telephone switching systems
7-year Manufacturing equipment, office furniture, fixtures
10-year Vessels, barges, tugs, railroad cars
15-year Waste-water plants, telephone- distribution plants, or similar utility property.
20-year Municipal sewers, electrical power plant.
27.5-year Residential rental property
39-year Nonresidential real property including elevators and escalators
ADR 4
4 10 ADR
10 16 ADR
16 20 ADR
20 25 ADR
25 ADR
MACRS Depreciation Schedules for Personal Property with Half-Year Convention
Property Class 3, 5, 7, 10-Year with 200% DB 15 and 20-Year with 150% DB
Sample Calculation – 5-Year MACRS:
MACRS Rate Calculation
Asset cost = $10,000Property class = 5-yearDB method = Half-year convention, zero salvage value, 200% DB switching to SL
20%
$2000
32%
$3200
Full
19.20%
$1920
Full
11.52%
$1152
Full
11.52%
$1152
Full
5.76%
$576
1 2 3 4 5 6
Half-year Convention
Year (n)
12
3
4
56
Calculation in %
(0.5)(0.40)(100%) 20%(0.4)(100%-20%) 32%
SL = (1/4.5)(80%) 17.78%
(0.4)(100%-52%) 19.20%
SL = (1/3.5)(48%) 13.71%
(0.4)(100%-71.20%) Switch to SL 11.52%SL = (1/2.5)(29.80%) 11.52%
SL = (1/1.5)(17.28%) 11.52%SL = (0.5)(11.52%) 5.76%
MACRS (%)
DDBDDB
DDB
SL
SL
Comparison between DDB with Switching to SL and MACRS Method
Conventional DDB Method:
Cost basis: $10,000 Salvage value: $0 Depreciable life: 5 years DB rate: 200%
MACRS Method: Property class: 5-year Salvage value: $0 Half-year convention
• Depreciation Rates
MACRS for Real Property
Types: 27.5-Year (Residential) 39-Year (Commercial)
SL Method Mid-month convention Zero salvage value
Example: Placed a residential property in service in March. Find the depreciation allowance in year 1. D1 = (9.5/12)(100%/27.5) = 2.8788%
Year (n) Calculation Allowed Depreciation (%)
1 (9.5/12)(100%/27.5) 2.8788%
2 100%/27.5 3.6364%
3 100%/27.5 3.6364%
4 100%/27.5 3.6364%
5 100%/27.5 3.6364%
6 100%/27.5 3.6364%
7 100%/27.5 3.6364%
8 100%/27.5 3.6364%
9 100%/27.5 3.6364%
10 (11.5/12)(100%/27.5) 3.4848%
Year (n) Calculation Allowed Depreciation (%)
1 (9.5/12)(100%/27.5) 2.8788%
2 100%/27.5 3.6364%
3 100%/27.5 3.6364%
4 100%/27.5 3.6364%
5 100%/27.5 3.6364%
6 100%/27.5 3.6364%
7 100%/27.5 3.6364%
8 100%/27.5 3.6364%
9 100%/27.5 3.6364%
10 (11.5/12)(100%/27.5) 3.4848%
Depreciation Allowances for a 10-year Ownership of the Property
Net Income Versus Cash Flow
Taxable Income and Income Taxes
Gross IncomeExpenses Cost of goods sold (revenues) Depreciation Operating expensesTaxable incomeIncome taxes
Net income
Item
Example:- Net Income Calculation
Item Amount
Gross income (revenue) $50,000
Expenses
Cost of goods sold
Depreciation
Operating expenses
20,000
4,000
6,000
Taxable income 20,000
Taxes (40%) 8,000
Net income $12,000
Capital Expenditure versus Depreciation
Expenses
01 2 3 4 5 6 7 8
0 87673 41 2
$4,000
$6,850$4,900
$3,500 $2,500 $2,500 $2,500$1,250
$28,000
Capital expenditure(actual cash flow)
Allowed depreciation expenses (not cash flow)
Cash Flow vs. Net Income
Net income: Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored.
Cash flow: Given the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, it is desirable why cash flows are relevant data to use in project evaluation.
Why Do We Use Cash Flow in Project Evaluation?
Company A Company B
Year 1 Net income
Cash flow
$1,000,000
1,000,000
$1,000,000
0
Year 2 Net income
Cash flow
1,000,000
1,000,000
1,000,000
2,000,000
Example: Both companies (A & B) have the same amount ofnet income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 millionat the end of 2nd year. Company A can invest $1 million in year1, while Company B has nothing to invest during the same period.
Example:– Cash Flow versus Net Income
Item Income Cash Flow
Gross income (revenue $50,000 $50,000
Expenses
Cost of goods sold
Depreciation
Operating expenses
20,000
4,000
6,000
-20,000
-6,000
Taxable income 20,000
Taxes (40%) 8,000 -8,000
Net income $12,000
Net cash flow $16,000
Net income versus net cash flow
$0
$50,000
$40,000
$30,000
$20,000
$10,000
$8,000
$6,000
$20,000
Net income
Depreciation
Income taxes
Operating expenses
Cost of goods sold
Netcash flow
Grossrevenue
$4,000
$12,000
Net cash flows = Net income + non-cash expense (depreciation)
Corporate Taxes
Taxable Income and Income Taxes
Gross IncomeExpenses Cost of goods sold (revenues) Depreciation Operating expensesTaxable incomeIncome taxes
Net income
Item
U.S. Corporate Tax Rate (2010)
Taxable income0-$50,000$50,001-$75,000$75,001-$100,000$100,001-$335,000$335,001-$10,000,000$10,000,001-$15,000,000$15,000,001-$18,333,333$18,333,334 and Up
Tax rate15%25%34%39%34%35%38%35%
Tax computation$0 + 0.15($7,500 + 0.25 ($13,750 + 0.34($22,250 + 0.39$113,900 + 0.34$3,400,000 + 0.35$5,150,000 + 0.38$6,416,666 + 0.35
(denotes the taxable income in excess of the lower bound of each tax bracket
Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000
Taxable income Marginal Tax Rate
Amount of Taxes
Cumulative Taxes
First $50,000 15% $7,500 $7,500
Next $25,000 25% 6,250 13,750
Next $25,000 34% 8,500 22,250
Next $235,000 39% 91,650 113,900
Next $9,665,000 34% 3,286,100 3,400,000
Next $5,000,000 35% 1,750,000 5,150,000
Remaining $1,000,000
38% 380,000 $5,530,000
Average tax rate =$5,530,000
$16, ,.
000 00034 56%
Example: Corporate Income Taxes
Facts:Capital expenditure $100,000(allowed depreciation) $58,000
Gross Sales revenue $1,250,000
Expenses:Cost of goods sold $840,000Depreciation $58,000Leasing warehouse $20,000
Question: Taxable income?
Taxable income:Gross income $1,250,000- Expenses:
(cost of goods sold) $840,000(depreciation) $58,000(leasing expense) $20,000
Taxable income $332,000
• Income taxes:First $50,000 @ 15% $7,500
$25,000 @ 25% $6,250$25,000 @ 34% $8,500$232,000 @ 39% $90,480
Total taxes $112,730
• Average tax rate:
Total taxes = $112,730Taxable income = $332,000
• Marginal tax rate:Tax rate that is applied to the last dollar earned
39%
Average tax rate =$112,730
$332,000
33 95%.
Disposal of Depreciable Asset
• If a MACRS asset is disposed of during the recovery period,
• Personal property: the half-year convention is applied to depreciation amount for the year of disposal. • Real property: the mid-month convention is applied to the month of disposal.
Disposal of a MACRS Property and Its Effect on Depreciation Allowances
Case 1: Salvage Value < Cost Basis
• Gains (losses) = Salvage value – book value
• These gains, commonly known as either ordinary gains or depreciation recapture, are taxed as ordinary income.
• Most gains experienced in manufacturing environment refer to these ordinary gains.
• Any losses (ordinary) can be deducted from the ordinary gains from other assets first and any remaining balance can be deducted from the ordinary taxable income.
Cost basis Book value Salvage value
Ordinary gains
Cost basis Book value Salvage value
Ordinary gains
Case 2: Salvage Value > Cost Basis
Gains = Salvage value – book value = (Salvage value - cost basis)
Capital gains
+ (Cost basis – book value)
Ordinary gains
Capital gain is taxed as ordinary income under current tax law.
Cost basis Book value Salvage value
Capital gains
Ordinary gainsor
depreciation recapture
Total gains
Cost basis Book value Salvage value
Capital gains
Ordinary gainsor
depreciation recapture
Total gains
Gains or Losses on Depreciable Asset
Example: A Drill press: $230,000Project year: 3 yearsMACRS: 7-year property classSalvage value: $150,000 at the end of Year 3
14.29 24.49 17.49 12.49 8.92 8.92 8.92
Full Full Half
Total Dep. = 230,000(0.1429 + 0.2449 + 0.1749/2) = $109,308Book Value = 230,000 -109,308 = $120,693Gains = Salvage Value - Book Value = $150,000 - $120,693
= $29,308Gains Tax (34%) = 0.34 ($29,308) = $9,965Net Proceeds from sale = $150,000 - $9,965 = $140,035
Calculation of Gains or Losses on MACRS Property