CTC 475 Review Public Projects Public Projects Why B/C ratio is used Why B/C ratio is used Pitfalls of the B/C ratio Pitfalls of the B/C ratio

CTC 475 Depreciation

Objectives Know the historical (SL, DB, SYD) and MACRS-GDS methods to determine book values and depreciation Know the historical (SL, DB, SYD) and MACRS-GDS methods to determine book values and depreciation

Tax Concepts Taxes affect cash flows Taxes affect cash flows Depreciation affects taxes Depreciation affects taxes Depreciation method is determined by law: Depreciation method is determined by law: Post ’86-MACRS (Modified Accelerated Cost Recovery System) Post ’86-MACRS (Modified Accelerated Cost Recovery System) ’81-’86 ACRS (Accelerated Cost Recovery System) ’81-’86 ACRS (Accelerated Cost Recovery System) Pre ’81-other methods (SL, DB, SYD) Pre ’81-other methods (SL, DB, SYD) SL-straight line; DB-declining balance; SYD- sum of the year’s digits SL-straight line; DB-declining balance; SYD- sum of the year’s digits

Depreciable Property 3 Requirements 1. Must be used in business or held for the production of income 2. Life can be determined and is longer than one year 3. Must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes

Depreciable Property Tangible (machines, cars, computers) Tangible (machines, cars, computers) Intangible (copyrights, franchises) Intangible (copyrights, franchises) Real (erected on land, growing on land, attached to land; however, land itself is not depreciable) Real (erected on land, growing on land, attached to land; however, land itself is not depreciable) Personal (machines, cars) Personal (machines, cars) Most depreciable property is tangible, personal Most depreciable property is tangible, personal

Adjusted Cost Basis Cost of property + Cost of property + Cost of additions + Cost of additions + Installation cost Installation cost

Book Value The worth of a depreciable property as shown on the accounting records The worth of a depreciable property as shown on the accounting records

Recovery Period Time over which cost basis can be recovered Time over which cost basis can be recovered For MACRS-GDS law sets as For MACRS-GDS law sets as 3,5,7,10,15, or 20 (for tangible property-see Table 7- 2; page 311) 3,5,7,10,15, or 20 (for tangible property-see Table 7- 2; page 311) 27.5 (for residential real property) 27.5 (for residential real property) 31.5/39 years (for nonresidential real property) 31.5/39 years (for nonresidential real property) The recovery period is usually shorter than the actual physical life The recovery period is usually shorter than the actual physical life

Examples 3-year property 3-year property Tractor units, special tools, race horses Tractor units, special tools, race horses 5-year property 5-year property Autos, buses, computers, office machinery Autos, buses, computers, office machinery 7-year 7-year Office furniture, theme/amusement park assets Office furniture, theme/amusement park assets 10-year property 10-year property Vessels, tugs, assets used in petroleum refining Vessels, tugs, assets used in petroleum refining 15-year property 15-year property Sewage treatment plants, sidewalks, roads, drainage facilities bridges, fencing, landscaping, transmission lines Sewage treatment plants, sidewalks, roads, drainage facilities bridges, fencing, landscaping, transmission lines 20-year property 20-year property Farm buildings Farm buildings

Depreciation Methods SL-straight line SL-straight line DB-declining balance DB-declining balance SYD-Sum of the years digits SYD-Sum of the years digits MACRS, GDS-modified accelerated cost recovery system, general depreciation system MACRS, GDS-modified accelerated cost recovery system, general depreciation system

Depreciation Methods-Example 7-year property 7-year property Basis is $100K Basis is $100K SV=0 SV=0

SL Example Depreciation is 1/7 (14.28%) * Cost Basis Depreciation is 1/7 (14.28%) * Cost Basis 14.28% * $100K = $14, % * $100K = $14,286

Straight Line Method EOYDepreciation Book Value 0-$100K 1$14,286$85,714 2$14,286$71,428 3$14,286$57,142 4$14,286$42,856 5$14,286$28,570 6$14,286$14,285 7$14,2850

What’s Wrong with this Method?

DB Example Cost Basis is $100K Cost Basis is $100K Depreciable Life is 7 years Depreciable Life is 7 years 200% DB % DB---- Depreciation is 2/7 (28.56%) * Book Value of previous year Depreciation is 2/7 (28.56%) * Book Value of previous year 150% DB----(not used for this example) 150% DB----(not used for this example) Depreciation would be 1.5/7 * Book Value of previous year Depreciation would be 1.5/7 * Book Value of previous year

Declining Balance Method EOYDepreciation Book Value 0-$100K %*$100K=$28,560$71, %*$71,440=$20,403$51, %*$51,036=$20,403$36, %*$36,460=$10,413$26, %*$26,047=$7,439$18, %*$18,608=$5,314$13, %*$13,294=$3,797$9,497

What’s Wrong with this Method?

SYD Example Cost Basis is $100K Cost Basis is $100K Depreciable Life is 7 years Depreciable Life is 7 years Number the depreciable life years in reverse order Number the depreciable life years in reverse order Sum up the numbers Sum up the numbers Year/Sum=Depreciation Amount applied to cost basis Year/Sum=Depreciation Amount applied to cost basis

SYD Method Year Reverse Order Depreciation Rate 177/28=25% 266/28=21.4% 355/28=17.8% 444/28=14.3% 533/28=10.7% 622/28=7.1% 711/28=3.5% Sum=28Sum=100%

SYD Method EOYDepreciation Book Value 0-$100K 1$25,000$75,000 2$21,428$53,572 3$17,857$35,715 4$14,286$21,429 5$10,714$10,715 6$7,143$3,572 7$3,5720

MACRS-GDS 3,5,7,10 yr (200% DBSLH) 3,5,7,10 yr (200% DBSLH) 15, 20 yr (150% DBSLH) 15, 20 yr (150% DBSLH) DBSLH (Declining Balance switching to Straight-Line depreciation at the optimum time with a Half-year convention) DBSLH (Declining Balance switching to Straight-Line depreciation at the optimum time with a Half-year convention) See table 7-3 (page 313) for depreciation rates which are multiplied by the cost basis See table 7-3 (page 313) for depreciation rates which are multiplied by the cost basis Note that the half-year convention extends depreciation rate one year beyond the recovery period (ex 4 vs 3 year) Note that the half-year convention extends depreciation rate one year beyond the recovery period (ex 4 vs 3 year)

MACRS-GDS Method EOYDepreciation Book Value 0-$100K %*$100K=$14,290$85, %*$100k=$24,490$61, %*$100K=$17,490$43, %*$100K=$12,490$31, %*$100K=$8,930$22, %*$100K=$8,920$13, %*$100K=$8,930$4, %*$100K=$4,460$0

Next lecture Taxes Taxes ATCF’s taking into account depreciation ATCF’s taking into account depreciation