CHAPTER 16

1. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 DEPRECIATION METHODS Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

2. 16 Preliminary Statement • The material presented in this chapter applies to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation. • As such, which changing legislation, parts of this chapter could be modified by legislation enacted after publication of this text. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

3. 16 Preliminary Statement • Students are encouraged to research the current depreciation rules as they may pertain to the material in this chapter. • The IRS web site { www.irs.gov } should be accessed for IRS Publication 946 for the current rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

4. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 Learning Objectives Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

5. 16 Learning Objectives • Depreciation Terminology • Straight-Line Depreciation • Double Declining Balance Depreciation • Modified Accelerated Cost Recovery System (MACRS) • Determining the MACRS Recovery Period Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

6. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 16.1 DEPRECIATION TERMINOLOGY Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

7. 16.1 Depreciation – Definition • Depreciation is the reduction of an asset’s value over time. • Brought on by: • Wear and tear, use; • Deterioration; • Obsolescence. • Other definitions follow: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

8. 16.1 Depreciation–Definition • Depreciation – Original Reason: • Purely economic! • Economic View: • Depreciation represents a “ratable” using up of devaluation of a productive asset. • The asset must have a finite life span that can be reasonably estimated. • Deprecation represents a proper charge against future income produced by the asset in question. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

9. 16.1 Depreciation and Depletion • Depreciation provides for the retirement of a productive asset; • Depletion provides for the use of a natural resource; • Amortization recognizes a prepaid expense for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

10. 16.1 Importance of Depreciation • Federal tax law defines the concept of “taxable income” as: • Gross Income – Real Cash Expenses – interest – Depreciation amounts. • Tax Due = • {Taxable Income}(Tax Rate). • Taxes and after-tax cash flows are presented in Chapter 17. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

11. 16.1 Tax Deductions • Federal Tax law permits the reduction of Gross Income by a category of elements termed “deductions”. • Most “deductions” are real cash flows: • Wages and salaries; • Cost of materials; • Utilities; • Interest Paid on debt; • State and local taxes paid; • Etc. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

12. 16.1 Tax Equation • The General Federal Tax Equation Is: Tax. Income = Gross Income – {Real Expenses + Interest Paid + Depreciation + Depletion} All of the above amounts EXCEPT depreciation amounts and depletion amounts are real cash flow to the firm. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

13. 16.1 Non-Cash Flow Amounts • Depreciation and depletion amounts represent “non-cash flow” amounts within an accounting period. • Federal and state tax laws recognize various forms of depreciation amounts and depletions amounts to be “tax- deductible amounts,” but are not real cash flows per se. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

14. 16.1 After-Tax Cash Flows • All “for profit” firms seek to minimize legally their respective income tax liabilities. • Depreciation and depletions amounts will lower the taxable income amount and hence the tax liability if claimed. • This chapter focuses on the various forms of depreciation and depletion calculations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

15. 16.1 Depreciation Amounts • Federal tax law states that: • Any productive asset with a finite life (greater than one year) must be depreciated for tax purposes rather than “expensed” in the year of purchase. • Depreciation amounts represent a prorated amount per year that can be treated as an “expense” (deduction), but is not a real cash flow. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16. 16.1 Tax Savings from Depreciation • Depreciation amounts represent a form of tax savings to the profitable firm. • Assume a tax rate of, say, 30%. • For every $1 of eligible deductions the resultant tax savings is: • (0.30)($1.00) = $0.30. • $1 of additional deductions saves the firm $0.30. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

17. 16.1 Simple Example • Consider a basic sewing machine that is used to sew shoes; • Assume this sewing machine sews 300,000 pairs of shoes, pair by pair. • The sewing machine is losing value over time due to the use of the machine. • An Economic Concept is at play…. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

18. 16.1 Simple Example • If the sewing machine costs $2,500 to begin with, then; • The initial cost of the sewing machine should be prorated over the 300,000 pairs of shoes. • The initial cost of the sewing machine is termed the BASIS of the asset. • One can allocate the original basis over the number of pairs of shoes the machine produces. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

19. 16.1 Types of Depreciation • Book Depreciation • Used by a firm for internal financial and managerial management. • Tax Depreciation • Used by a firm for state and federal income tax reporting. • Follows strict rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

20. 16.1 Book Depreciation • Value of the asset on the firm’s accounting records at any given point in time. • Used for internal managerial decision making. • Management is free to use any method they so choose to compute book depreciation amounts. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

21. 16.1 Book Depreciation • Used internally by the firm; • Be any method: • Straight Line, • Declining Balance; • Sum-of-the-years digits; • Other. • Defines the reduced investment in an asset based upon usage pattern and an assumed life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

22. 16.1 Tax Depreciation • Tax Depreciation: • Must follow current state and federal law pertaining to acceptable methods for computing depreciation for income tax purposes. • Federal Lever (2001) • MACRS Methods • General Depreciation System (GDS). • Alternate Depreciation System (ADS). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

23. 16.1 Book Value of an Asset • Book value: • Accounting Term, • Reflects the undepreciated (value) on the firm’s books at a given point in time. • May or may not reflect the true market value of the asset at a point in time. • Market value of an asset is what a willing buyer and willing seller agree to consummate a sale or exchange. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

24. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 DEPRECIATION TERMINOLOGY Important Terms and Their Meanings Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

25. 16.1 Terminology • The following slides state and define depreciation terminology; • Terminology is very important to the understanding of this chapter; • Please focus on the terms and their respective meanings. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

26. 16.1 BASIS of an Asset (B) Terms • The Basis of an asset is: • Purchase cost plus, • Delivery costs plus, • Installation costs and, • Any other costs associated with installing and preparing the asset for use. • To be eligible for depreciation, the asset MUST be placed in-service and ready for use. • Symbol: B for “Basis” – a dollar amount. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

27. 16.1 Book Value of an Asset (BVt) Terms • The remaining, undepreciated capital investment on the firm’s books after the accumulated amounts of depreciation have been subtracted from the original cost basis. • BV’s are usually updated at the end of the firm’s accounting year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

28. 16.1 Recovery Period - n Terms • Recovery Period (in years) is the depreciable life nof the asset in years. • Often there are different n values for book and tax depreciation. • Both of these values may be different from the asset's estimated productive life. • Also known as the Depreciable Life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

29. 16.1 Market Value (MVt) Terms • Market value, a term also used in replacement analysis, is the estimated amount realizable if the asset were sold on the open market. • Because of the structure of depreciation laws, the book value and market value may substantially differ. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

30. 16.1 Market Value (MVt) Terms • For example, a commercial building tends to increase in market value, but the book value will decrease as depreciation charges are taken. • A computer workstation may have a market value much lower than its book value due to rapidly changing technology. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

31. 16.1 Salvage Value –S Terms • Salvage value is the estimated trade-in or market value at the end of the asset's useful life. • The salvage value, S, expressed as an estimated dollar amount or as a percentage of the first cost, may be positive, zero, or negative due to dismantling and carry-away costs. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

32. 16.1 Salvage Value –S Terms • Salvage values are estimated “up-front” – at the time of the original purchase. • As an estimated value, the actual salvage value out at time t = n may or may not reflect the original estimate. • Generally speaking, one cannot depreciate an asset below its estimated salvage value. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

33. 16.1 Depreciation Rate –dt Terms • Depreciation rate or recovery rate is the fraction of the first cost removed by depreciation each year. • This rate, denoted by dt, may be the same each year, which is called the straight-line rate, or different for each year of the recovery period. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

34. 16.1 Personal Property Terms • Personal property, one of the two types of property for which depreciation is allowed, is the income-producing, tangible possessions of a corporation used to conduct business. • Not to be confused with an individual’s personal property like clothes, furniture, etc. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

35. 16.1 Personal Property – continued Terms • Included are: • most manufacturing and service industry property vehicles, • manufacturing equipment, materials handling devices, computers, and networking equipment, • telephone equipment office furniture, refining process equipment, and much more. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

36. 16.1 Real property Terms • Real property includes: • real estate and all improvements • office buildings, • manufacturing structures, • test facilities, • warehouses, • apartments, and other structures. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

37. 16.1 Real Property Terms • Real property includes real estate and all improvements – office buildings manufacturing structures, test facilities, warehouses, apartments, and other structures. • Land itself is considered real property, but it is not depreciable because it has an infinite life – land can never be depreciated for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

38. 16.1 The Half-Year Convention Terms • During a tax year, assets are purchased and installed throughout the first year. • Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year. • Under current federal tax law the first year is handled using the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

39. 16.1 The Half-Year Convention Terms • The half-year convention assumes that assets are placed in service or disposed of in midyear, regardless of when these events actually occur during the year. • This convention is utilized in this text and in most U.S.-approved tax- depreciation methods. • There are also mid-quarter and mid-month conventions. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

40. 16.1 Property Eligible for Depreciation Terms • Real or personal; • Productive assets; • Buildings and structures, but not land. • Used in the pursuit of income generation; • Have a finite, estimatable life Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

41. 16.1 Section “38” Property Terms • Often the term “Section 38,” or Section 1238,” is used: • Section 1238 (from the IRS Code, Section 1238) is defined as: • Tangible personal property (but not buildings or their structural components) that is eligible for depreciation under the federal tax code. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

42. 16.1 Code Section 1250 Property Terms • Under the IRS Code, Section 1250 property is “real” property: • Buildings and structures eligible for depreciation. • Summary: • Section 1238 – Personal Property, • Section 1250 – Real Property. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

43. 16.1 Depreciation Models • Basic (traditional) models are: • Straight-Line Method (SL), • Sum-of-the-Years Digits Method (SYD), • Declining Balance Method (DB). • Today, the MACRS Method (a form of declining balance-modified). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

44. 16.1 Classical Methods • Classical Methods (supporting Excel functions) are: • Straight-line, • SYD; • DB. • See Appendix at the end of chapter 16. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

45. 16.1 Section 179 Deduction • Section 179 Deduction: • Special provision of the tax code • Benefits the small business • Provides an economic incentive for small businesses to invest in assets required to produce a profit • Permits the “expensing” of up to a certain amount of investment in depreciable assets in a given tax year (one-year write-off). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

46. 16.1 Section 179 Allowance • The 179 allowance can reduce the current year’s income tax liability. • Has a statutory maximum: • For 2001 – max. amount = $24,000 • For 2003 – increases to $25,000. • If more than $200,000 is invested in a given year, the 179 amount is reduced dollar for dollar. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

47. 16.1 History • Before 1981 – U.S. code recognized the classical methods. • 1981 and after: • Classical methods were disallowed for federal tax purposes and replaced with a system termed ACRS – Accelerated Capital Recovery System • In 1986 ACRS was replaced with MACRS – Modified Accelerated Capital Recovery System. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

48. 16.1 Today…. • U.S. Federal Corporate Income Taxes must be computed using the MACRS system! • States that have corporate income tax laws generally permit all or part of the classical methods to be used for state corporate tax analysis. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

49. 16.1 Comparison of Methods • It is beneficial to compare: • Straight-line, • SYD, and • DB methods. • The best way is to plot the book values of each method vs. the recovery period (time). • See Figure 16.1 on page 510. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

50. 16.1 Book Value vs. Time: General Case • In general, a book value plot will look like: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University