1. ALI SALMAN1 LECTURE - 12 ASST PROF. ENGR ALI SALMAN alisalman@ ceme.nust.edu.pk DEPARTMENT OF ENGINEERING MANAGEMENT COLLEGE OF E & ME, NUST DEPARTMENT OF ENGINEERING MANAGEMENT COLLEGE OF E & ME, NUST ENGINEERING ECONOMICS

2. Depreciation Depreciation may be defined as the decrease in the value of physical assets with the passage of time as a result of wear, deterioration and technological obsolescence. It is used in the books of accounts for preparing a balance sheet of assets. Depreciation is viewed as a part of business expenses that reduce taxable income. Why Do We Consider Depreciation?

3. Depreciation Example You purchased a car worth $15,000 at the beginning of year 2004. Depreciation End of Year Market Value Loss of Value 012345012345 $15,000 10,000 8,000 6,000 5,000 4,000 $5,000 2,000 1,000

4. Factors to Consider in Asset Depreciation  Depreciable life (how long?)  Salvage value (disposal value)  Cost basis (depreciation basis)  Method of depreciation (how?) Salvage value is the price of an equipment that can be obtained after it has been used.

5. What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above.

6. Cost Basis Cost of a new hole-punching machine (Invoice price) $62,500 + Freight725 + Installation labor2,150 + Site preparation3,500 Cost basis to use in depreciation calculation $68,875 Depreciation Methods Straight-Line Method Declining Balance Method Unit Production Method

7. Straight Line (SL) Method This method assumes a uniform decrease in the value of asset with the passage of time. Formula Annual Depreciation D n = (I – S) / N, and constant for all n. Book Value B n = I – n (D) where I = cost basis/value S = Salvage value N = depreciable life Book value is the worth of an asset as shown on the accounting record of a company.

8. Example – Straight Line Method D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 1 2 3 4 5 Total depreciation at end of life nD n B n 11,6008,400 21,6006,800 31,6005,200 41,6003,600 51,6002,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N Annual Depreciation Book Value n

9. Declining Balance Method In this method the depreciation cost is highest in the first year and reduces year after year. Formula Annual Depreciation Book Value where 0 <  < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. n

10. Example – Declining Balance Method D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 1 2 3 4 5 Total depreciation at end of life $778 Annual Depreciation Book Value n012345n012345 D n $4,000 2,400 1,440 864 518 B n $10,000 6,000 3,600 2,160 1,296 778 n 

11. Example – Declining Balance Method (if B<salvage value) D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 1 2 3 4 5 Total depreciation at end of life $778 Annual Depreciation Book Value n012345n012345 D n $4,000 2,400 1,440 160 0 B n $10,000 6,000 3,600 2,160 2000 n

12. When S = $2,000 End of Year DepreciationBook Value 10.4($10,000) = $4,000$10,000 - $4,000 = $6,000 20.4(6,000) = 2,4006,000 – 2,400 = 3,600 30.4(3,600) = 1,4403,600 –1,440 = 2,160 40.4(2,160) = 864 > 1602,60 – 160 = 2,000 502,000 – 0 = 2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.

13. Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation D n = Service units consumed for year total service units (I - S)

14. Example Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles Solution:

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