1. Chap 10 Depreciation is a decline in market or asset value of physical properties caused by deterioration or obsolescence. It represents a legal loss of value for tax purposes. Depreciation involves a systematic allocation of the cost of an asset over its depreciable life. The annual depreciation expense is deductible for income tax calculations. EGR 403, Jan 99

2. Depreciable property * Tangible 1) Real 2) Personal * Intangible To be depreciable: must be used in business determinable life > 1 year wears out Consider period of service not period of ownership EGR 403, Jan 99

3. Definitions of Value * Market Value: Cost of a property when both buyer and seller have equal advantage and are under no compulsion to buy or sell. * Salvage (resale) Value (S): Price that can be obtained from the sale of the property * Book Value: Original cost (P) of a property less the amounts that have been charged as depreciation expense. * Adjusted Basis Value: Book value plus the cost of improvements, additions, and other capital costs, commissions, legal fees, etc. minus certain credits. This value is essential in calculating the taxable profit or loss from the sale of property. EGR 403, Jan 99

4. Income Statement Jan. 1 to Dec. 31, 2000 Revenue $300,000 Expenses: Depreciation $60,000 Expenditures $90,000 Taxable income $150,000 Income tax $40,000 Net income after tax $110,000 Engineering Economy: Revenue $300,000 Less expenditures $90,000 Cash flow before tax $210,000 Less tax $40,000 Cash flow after tax $170,000 EGR 403, Jan ‘00

5. Notations: P: initial cost, S: salvage value, N: useful life Depreciation Methods: Straight line (S.L.) Depreciation: Annual depreciation charge = (P-S)/N Book value at end of year n = P - n(P-S)/N n = 1......N Sum-of-Years Digits (SOYD) Depreciation Sum-of-Years Digits = SOYD = N(N+1)/2 Depreciation for year n = (N-n+1)[(P-S)/SOYD] Declining Balance Depreciation: DDB Depreciation in any year = 2(Book Value)/N = 2(Cost - Depreciation charges to date)/N Implied Salvage value at the end of N years = P(1 - 2/N) EGR 403, Jan 99

6. Modified Accelerated Cost Recovery System (MACRS) The newest depreciation method that may be used for U.S. income tax purposes. Assumptions: DDB with switch to SL, zero salvage value, midpoint life Steps: 1) Determine the property class of the asset. 2) Read the depreciation percentages from the table. EGR 403, Jan 99

7. To calculate tax: 1- Find taxable income *For individuals = Adjusted gross income - Personal exemptions - Itemized deductions or Standard deductions *For business = Gross income - Expenditures (not capital) - Depreciation 2- Use related tax rates table Find the tax bracket and use its marginal tax rate EGR 403, Jan 00

8. Economical analysis for a new equipment: *Initial cost of the equipment is $50,000 depreciated SL for 3 years >> D = $16,667 *Will generate gross income of $30,000 and expenses of $10,000 (taxable income $20,000) for 3 years *The marginal tax rate is 34% (i.e. 90,000 current taxable income) YearCash flow (wrong)Taxable incomeTaxNet income 120000-5000020000-1666711332200 22000020000-16667 11332200 32000020000-1666711332200 YearBefore taxTaxableTaxafter tax cash flow Dep.income.34%cash flow 0-50000-50000 120000 1666720000-16667113318867 220000 1666720000-16667113318867 320000 1666720000-16667113318867 EGR 403, Jan 00

9. Effect of tax on loan:

10. Loan payment is not an expense, but interest portion is. End of Loan Interest Reduction in Cash flow year payment portion tax t=10% after tax. 1 527.6 200 20 527.6-20 = 507.6 2 527.6 167.24 3 527.6 131.2 4 527.6 91.56 5 527.6 47.96 EGR 403, Jan 00

11. Income Tax Incremental (Marginal) tax rate Combined Federal and State Income Taxes: Combined incremental tax rate = incremental State tax rate + (incremental Federal tax rate)*(1 - incremental State tax rate) Capital Gains and Losses Capital {gain or loss} = Selling price - Book value EGR 403, Jan 99

12. Replacement Analysis Defender and Challenger Shall we replace the defender now, or shall we keep it for one or more additional years? Minimum cost life: number of years at which the EUAC of ownership is minimized. Marginal costs: year-by-year costs EGR 403, Jan 99