EML4550 - Engineering Design Methods

1. EML4550 - Engineering Design Methods Engineering-Economics Depreciation & Taxes Hyman, Chapter 8

2. General Definitions • Market value: The price at which consumers in the open market are willing to pay for a product or service. • Generally, market value is less than the value to owner • Book value: an asset value minus the depreciation expense and other liabilities taken to date • Depreciation: the allowance for loss of an asset value due to age, ordinary wear and tear, degraded functionality, etc.. • Has a tax-saving consequence as a cost of doing business • Taxable income = total income - allowable expenses – depreciation • Depreciation is treated as an expense (tax deductible) • An asset can be depreciated over a period of time with specified amount depending on the nature of the asset.

3. Depreciation • Straight line: one can set aside a fixed depreciation amount of money yearly. • Modified Accelerated Cost Recovery System (MACRS) • Economic Recovery Act (1981)  ACRS • Tax reform Act (1986)  MACRS • Special manufacturing devices; some motor vehicles: 3 years • Computers; trucks; semiconductor manufacturing equipment: 5 years • Office furniture; railroad track; agricultural building: 10 years • Sewage treatment plants; telephone systems: 15 years • Residential rental property: 27.5 years • Nonresidential rental property: 31.5 years

4. MACRS • The annual depreciation amount is calculated using the recovery rate q given in the table D=qCi • The asset value is completely depreciated even though there may be a true salvage value • MACRS assumes the investment is placed at the midpoint of the initial year. Therefore, only 50% of the first year depreciation applies for tax purpose. • As a result, a half year of depreciation be taken in year n+1

5. Example • An equipment has an initial capital cost of $10,000 and a salvage value of 2,000. The total useful period is 5 years. Compare the annual depreciation amount using either the straight line or the MACRS calculation.

6. Total Income Operating Expenses Depreciation Taxable Income Taxes Taxes • A financial charge by the government on a product, income or activity. • Property taxes, sales taxes (by buyers), excise taxes (non-essential goods like tobacco, liquor), income taxes • Corporate federal graduated tax schedule (table 8.10) • Only impose on taxable income after deducting operating expenses and depreciation. • If there is a state tax, it is usually exempted from federal taxes, therefore, effective tax rate = state rate + (1- state rate) (federal rate)

7. Example A company earns a gross income of $10M. Operating expenses are estimated at $6M and depreciation is $1.5M. (a) Determine the average federal income taxes w/o state taxes; (b) assume the state tax rate is 7%, what is the effective tax rate? (a) Net income=10 - 6 - 1.5=$2.5M Taxes=(50,000)(0.15)+(25,000)(0.25)+(25,000)(0.34)+(235,000)(0.39) +(2,500,000-335,000)(0.34)=7,500 +6,250+8,500+91,650+736,100=$850,000 average tax rate=850,000/2,500,000=0.34 (b) Effective tax rate = 0.07 + (1 – 0.07)(0.34) = 0.40

8. Example Next page • For motor A • Depreciation: 2nd yr - 9.6 • Tax benefit @0.34- 3.26 • (-3.26)[P/F] 0.2, 2 • =(-3.26)(0.694)=-2.26 this can • be deducted as expenses thus decreasing present value of motor A.

9. Example (cont.) • for motor A maint.+electoperating expenses=2.99+9.75=12.74 • tax benefit @0.34-4.33 • Productivity benefit+salv.= • -1.5-1.61=-3.11 • This can be considered income to the company  need to pay income taxes @0.34 • (3.11)(0.34)=1.06 • It is positive since we over-estimate the benefit by not considering income taxes previously. We need to add this to the expense category for the motor

10. Inflation • Consumer Price Index (CPI): a composite price index to measure average change over time in the prices paid by urban consumers for a market basket of consumer goods and services such as food, shelter, transportation, apparel, etc.. • 1982-1994: 3.33%, 1994-2004: 2.59% • Producer Price Index (PPI): this program measures the average change over time in the selling prices received by domestic producers for their output. • Commodity classification • Finished goods (ex. Automobiles, TV) • Intermediate materials, supplies (ex. Flour, steel products, lumber, etc..) • Crude materials (ex. Grains, livestock, crude oil, coal, etc..) • Industrial classification • Air transportation, power, grocery, etc..

11. Real Discount Rate • Due to annual inflation, the real value (purchasing power) of the money will be decreased accordingly. This reduction can effectively change the real investment rate (interest rate) as: • If we assume the average annual inflation rate is f=0.03, then the nominal interest rate of 20%=0.2 will need to be modified to get the real discount rate • If the inflation rate is small, then ireal inom – f=0.2-0.03=0.17 (about 3% difference w.r.t. 0.165)