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16-1 Lecture slides to accompany Engineering Economy 7 th edition Leland Blank Anthony Tarquin Chapter 16 Depreciation Methods © 2012 by McGraw-Hill All Rights Reserved

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16-2 LEARNING OUTCOMES 1.Understand basic terms of asset depreciation 2.Apply straight line method of depreciation 3.Apply DB and DDB methods of depreciation 4.Apply MACRS method of depreciation 5.Select asset recovery period for MACRS 6.Explain depletion and apply cost depletion & percentage depletion methods © 2012 by McGraw-Hill All Rights Reserved

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16-3 Depreciation Terminology Definition: Book method to represent decrease in value of an asset w/time Two types: book depreciation & tax depreciation Book depreciation : used for internal accounting to track value of assets Tax depreciation : used to determine taxes due based on tax laws In U.S., tax depreciation must be calculated using MACRS ; book depreciation can be calculated using any method

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16-4 Common Depreciation Terms © 2012 by McGraw-Hill All Rights Reserved First cost P or unadjusted basis: total installed cost of asset Book value: remaining undepreciated capital investment Recovery period: depreciable life of asset in years Market value: amount realizable if asset were sold in open market Salvage value: trade-in or market value at end of asset’s useful life Depreciation rate: fraction of first cost removed by depreciation each year Personal property: possessions of company used to conduct business Real property: real estate & all improvements (land not depreciable) Half-year convention: assumes assets are placed in service in midyear

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16-5 Straight Line Depreciation © 2012 by McGraw-Hill All Rights Reserved Book value decreases linearly with time D t = B - S n Where: D = annual depreciation charge t = year B = first cost or unadjusted basis S = salvage value n = recovery period BV t = B - tD t Where: BV t = book value after t years

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16-6 Example SL Depreciation © 2012 by McGraw-Hill All Rights Reserved Solution: (a ) D 3 = (P – S)/n = (20,000 – 5000)/5 = $3000 (b) BV 3 = B – tD t = 20,000 – 3(3000) = $11,000 A certain machine has a first cost of $20,000 with a $5,000 salvage value after 5 years. Find D and BV for year three.

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16-7 Declining Balance Depreciation © 2012 by McGraw-Hill All Rights Reserved Determined by multiplying BV at beginning of year by fixed percentage, d Max rate for d is twice straight line rate = 2/n Cannot depreciate below book value Depreciation for year t is given by: D t = dB(1 – d) t-1 where: D t = depreciation for year t t = depreciation year d = uniform depreciation rate (2/n for DDB) B = first cost or unadjusted basis Book value for year t is given by: BV t = B(1 – d) t

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16-8 Example Declining Balance © 2012 by McGraw-Hill All Rights Reserved (b) BV 3 = B(1 – d) t = 20,000(1 – 0.4) 3 = $4320 A certain machine has a first cost of $20,000 with a $4,000 salvage value after 5 years. Find (a) the depreciation, and (b) the book value after 3 years using DDB depreciation. Solution: (a) d = 2/n = 2/5 = 0.4 D 3 = dB(1 – d) t-1 = 0.4(20,000)(1 – 0.40) 3-1 = $2800

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16-9 MACRS Depreciation © 2012 by McGraw-Hill All Rights Reserved Required method to use in U.S. for tax depreciation Can depreciate to below salvage value D t = d t B Where: D t = depreciation charge for year t t = year B = first cost or unadjusted basis BV t = B - ∑D j Where: BV t = book value after t years D j = depreciation in year j J=1 J=t Get value for d t from table

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16-10 Example: MACRS Depreciation © 2012 by McGraw-Hill All Rights Reserved Solution: A certain machine has a first cost of $20,000 with a $5,000 salvage value after 5 years. Find (a) D and (b) BV for year 3 (a) From table, d 3 = 19.20 D 3 = 20,000(0.1920) = $3,840 (b) BV 3 = 20,000 - 20,000(0.20 + 0.32 + 0.192) = $5,760

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© 2012 by McGraw-Hill All Rights Reserved 16-11 MACRS Recovery Period Recovery period (i.e. n) is function of property class Two systems for determining recovery period: general depreciation system (GDS) alternative depreciation system(ADS) IRS publication 946 gives n values for each system. For example: n value Asset description GDS ADS range Special manufacturing devices, racehorses, tractors 3 3 - 5 Computers, oil drilling equipment, autos, trucks, buses 5 6 - 9.5 Office furniture, railroad car, all property not in other class 7 10 – 15 Nonresidential real property (not land itself) 39 40

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16-12 © 2012 by McGraw-Hill All Rights Reserved Depletion Methods Depletion represents decreasing value of natural resources Two methods: cost depletion and percentage depletion Cost depletion: Multiply factor by amount of resource removed where factor, CD t = first cost / resource capacity Percentage depletion: Multiply gross income by PD % from Table

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© 2012 by McGraw-Hill All Rights Reserved 16-13 Example: Depletion A silver mine purchased for $3.5 million is expected to yield one million ounces of silver. Determine the depletion charge in a year when 300,000 ounces are mined and sold for $30 per ounce by (a) Cost depletion, and (b) Percentage depletion. Solution: (a)Cd t = 3,500,000/ 1,000,000 = $3.50 per ounce Cost depletion = 3.50(300,000) = $1,050,000 (b) Percentage depletion = 300,000(30)(0.15) = $1,350,000

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16-14 Summary of Important Points © 2012 by McGraw-Hill All Rights Reserved Two methods of depletion: cost (amount resource removed* CD t factor) & percentage (income*PD % from table) Two methods for depreciation: tax and book In U.S., MACRS method is used for tax depreciation Two systems for determining recovery period: GDS & ADS Depletion (instead of depreciation) used for natural resources

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