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MIE 754 - Class #7 Manufacturing & Engineering Economics. No Class Meeting this Thurs (10/4/01) Concerns and Questions Quick Recap of Previous Class Today’s Focus: Chapter 6: Depreciation (continued) and Taxes Assignment 1 - Graded Due in 2 Weeks
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MIE 754 - Class #7 Manufacturing & Engineering Economics • No Class Meeting this Thurs (10/4/01) • Concerns and Questions • Quick Recap of Previous Class • Today’s Focus: • Chapter 6: Depreciation (continued) and Taxes • Assignment 1 - Graded Due in 2 Weeks • Refer to course web site for instructions and materials • Homework Problems Due in 1 Week (next pg)
Concerns and Questions? • No Class Meeting this Thurs (10/4) • Homework Due in 1 Weeks: • Chap 3 - 5, 9, 14, 19, 21, 23 • Chap 4 - 6(a), 12, 16, 26(IRR only) • Chap 6 - 6(a, c, d), 17(c), 20, 25, 30 • Homework and Assignment Tracking
Quick Recap of Previous Class • Internal Rate of Return • Comparing Alternatives • Basic Rule and Steps • Depreciation • What is it? Why bother? • Straight Line • Declining Balance
Straight Line Method A constant amount is depreciated each year over the asset's life. dk = (B - SVN) / N for k = 1, 2, ..., N (6-1) dk* = k(dk) for 1 k N (6-2) BVk = B - dk* (6-3)
Declining Balance Method Annual depreciation is a constant percentage of the asset's value at the BOY. d1= B(R) (6-4) dk = B(1-R)k-1(R) = BVk-1(R) (6-5) dk* = B[1 - (1 - R)k] (6-6) BVk = B(1 - R)k (6-7) BVN = B(1 - R)N (6-8) R = 2/N 200% declining balance, or R = 1.5/N 150% declining balance • Uses the useful life (or class life) for N • Does not consider SVN
SL and DB Example • A computer was purchased for $20,000 and $2,000 was spent installing it. The computer has an estimated salvage value of $4,000 at the end of its class life. Compute the depreciation deduction in year 3 and the book value at the end of year 6 using: a) straight-line method b) 200% declining balance method
Step 0. Compute the Cost Basis (B) B = $20,000 + $2,000 = $22,000 Step 1. Determine the Class Life From Table 6-2, N = 6 years • Straight Line Method BV6= B - dk* = 22,000 - (6(3,000)) = $4,000
200% Declining Balance R = 2/6 = 1/3 = 0.33 d3 = B (1-R)k-1(R)= 22,000(0.67)2(0.33) = $3,259 BV6 = B (1-R)k = 22,000(0.67)6 = $1,931 d6* = 22,000{1-(1-0.33)6} = $20,069 Note:BV6 = B - d6* = 22,000 - 20,069 = $1,931
MACRS (GDS) METHOD Annual depreciation is a fixed percentage of the cost basis (percentage specified by the IRS). Mandatory for most assets. dk = rkB Step 1. Determine the property class (recovery period) from Table 6-2 or Table 6-3 Step 2. Use Table 6-4 to obtain GDS rates, rk Step 3. Compute depreciation deduction in year k by multiplying the asset’s cost basis by the appropriate recovery rate, rk. Remember: MACRS is spread over N + 1 years due to half-year convention
Previous Example by MACRS Method Step 0. Compute the Cost Basis (B) for the Computer B = $20,000 + $2,000 = $22,000 Step 1. Determine the Property Class (Recovery Period) From Table 6-2 = 5 year Recovery Period Steps 2 and 3 shown in the following table:
Example • 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, and (c) the MACRS method. • depreciation deduction in the first year and the fourth year • cumulative depreciation through year four • book value at the end of the fourth year
First, calculate the cost basis. B = $10,000 + $85,000 = $95,000 • Next, determine the depreciable life. • From Tables 6-2 and 6-3the class life = 9 years and the GDS recovery period = 5 years for buses.
Example Straight-Line Method • Assume SV9 = $5,000 dk = (95,000-5,000)/9= $10,000/yr for k = 1 to 9 1. d1 = d4 = $10,000 2. d4*= 4 ($10,000) = $40,000 3. BV4 = B - d4* = $95,000 - $40,000 = $55,000
An after-tax evaluation of a project's after-tax cash flows requires an after-tax MARR
When an asset is disposed of for more (less) than its book value, the resulting gain (loss) is taxed • Depreciation recapture and capital gains (losses) are taxed as ordinary income. • Capital Gain (Loss) = MV - BV • If an asset is sold for less than its current book value (MV < BV), it is termed a capital loss, and taxes on the loss represent a tax credit.
Lease vs. Purchase Example • Determine the more economic means of acquiring a copier in your business if you may either (a) purchase the copier for $5,000 with a probable resale value of $1,000 at the end of 5 years or (b) 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 MACRS 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%.
