Depreciation and Income Taxes Chapter 9 Advanced Engineering Economy

Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year Depreciation End of Year Market Value Loss of Value $15,000 10,000 8,000 6,000 5,000 4,000 $5,000 2,000 1,000

Why Do We Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income.

Factors to Consider in Asset Depreciation  Depreciable life (how long?)  Salvage value (disposal value)  Cost basis (depreciation basis)  Method of depreciation (how?)

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.

Cost Basis  Without Trade-In Allowance  With Trade-In Allowance

Useful Life and Salvage Value  Useful life – Adopt the Asset Depreciation Ranges (ADR) published by the IRS.  Salvage value – Asset’s estimated value at the end of its useful life. Every effort should be made to estimate a reasonable residual value of the asset, but if not possible, a 10% rule (10% of the initial value) could be adopted for depreciation purpose.

Types of Depreciation Book Depreciation –In reporting net income to Investors/stockholders –In pricing decision Tax Depreciation –In calculating income taxes for the IRS –In engineering economics, we use depreciation in the context of tax depreciation

Book versus Tax Depreciation – An Overview Component of Depreciation Book DepreciationTax depreciation (MACRS) Cost basis Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc. Same as for book depreciation Salvage value Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations. Salvage value is zero for all depreciable assets

Component of Depreciation Book DepreciationTax depreciation (MACRS) Depreciable life Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs) Eight recovery periods– 3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories. Method of depreciation Firms may select from the following: Straight-line Accelerated methods (declining balance, double declining balance, and sum-of- years’ digits) Units-of-proportion Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight-line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.

Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: –Straight-Line (SL) Method –Declining Balance Method –Unit Production Method

Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation D n = (I – S) / N, and constant for all n. Book Value B n = I – n (D) where I = cost basis S = Salvage value n = depreciable life

Example: Straight-Line Method D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2, Total depreciation at end of life nD n B n 0 10,000 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

Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion 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% DDB or Double Declining Balance method.

Example: Declining Balance Method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2, Total depreciation at end of life $778 Annual Depreciation Book Value n012345n D n $4,000 2,400 1, B n $10,000 6,000 3,600 2, n ά =2(1/N) =2(1/5) =40%

Example: DB Switching to SL SL Dep. Rate = 1/5  (DDB rate) = (200%) (SL rate) = 0.40 Asset:Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base$10,000 Salvage Value 0 Depreciation200% DB Depreciable life5 years

nDepreciation Book Value ,000(0.4) = 4,000 6,000(0.4) = 2,400 3,600(0.4) = 1,440 2,160(0.4) = 864 1,296(0.4) = 518 $6,000 3,600 2,160 1, n Book Depreciation Value ,000 $6,000 6,000/4 = 1,500 < 2,4003,600 3,600/3 = 1,200 < 1,4402,160 2,160/2 = 1,080 > 8641,080 1,080/1 = 1,080 > (a) Without switching(b) With switching to SL Note: Without switching, we have not depreciated the entire cost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits. Case 1: S = 0

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

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)

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

Tax Depreciation

Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, DB) Assets placed in service from 1981 to 1986 Use Accelerated Cost Recovery System (ACRS) Table Assets placed in service after 1986 Use Modified Accelerated Cost Recovery System MACRS Table

Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value

MACRS Property Classifications Recovery PeriodADR Midpoint Class Applicable Property 3-yearSpecial tools for manufacture of plastic products, fabricated metal products, and motor vehicles. 5-yearAutomobiles, light trucks, high-tech equipment, equipment used for R&D, computerized telephone switching systems 7-yearManufacturing equipment, office furniture, fixtures 10-yearVessels, barges, tugs, railroad cars 15-yearWaste-water plants, telephone- distribution plants, or similar utility property. 20-yearMunicipal sewers, electrical power plant yearResidential rental property 39-yearNonresidential real property including elevators and escalators

MACRS Depreciation Schedules for Personal Property with Half-Year Convention  Property Class  3, 5, 7, 10-Year with 200% DB  15 and 20-Year with 150% DB  Sample Calculation – 5- Year MACRS:

MACRS Rate Calculation Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL 20% $ % $3200 Full 19.20% $1920 Full 11.52% $1152 Full 11.52% $1152 Full 5.76% $ Half-year Convention

Year (n) Calculation in % (0.5)(0.40)(100%)20% (0.4)(100%-20%)32% SL = (1/4.5)(80%)17.78% (0.4)(100%-52%)19.20% SL = (1/3.5)(48%)13.71% (0.4)(100%-71.20%)Switch to SL11.52% SL = (1/2.5)(29.80%)11.52% SL = (1/1.5)(17.28%)11.52% SL = (0.5)(11.52%)5.76% MACRS (%) DDB SL

Comparison between DDB with Switching to SL and MACRS Method  Conventional DDB Method:  Cost basis: $10,000  Salvage value: $0  Depreciable life: 5 years  DB rate: 200%  MACRS Method:  Property class: 5- year  Salvage value: $0  Half-year convention Depreciation Rates

MACRS for Real Property  Types:  27.5-Year (Residential)  39-Year (Commercial)  SL Method  Mid-month convention  Zero salvage value  Example: Placed a residential property in service in March. Find the depreciation allowance in year 1. D 1 = (9.5/12)(100%/27.5) = %  Depreciation Allowances for a 10-year Ownership of the Property

Net Income Versus Cash Flow

Taxable Income and Income Taxes Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Item

Example:- Net Income Calculation ItemAmount Gross income (revenue)$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6,000 Taxable income20,000 Taxes (40%)8,000 Net income$12,000

Capital Expenditure versus Depreciation Expenses $4,000 $6,850 $4,900 $3,500$2,500 $1,250 $28,000 Capital expenditure (actual cash flow) Allowed depreciation expenses (not cash flow)

Cash Flow vs. Net Income Net income : Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow : Given the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, it is desirable why cash flows are relevant data to use in project evaluation.

Why Do We Use Cash Flow in Project Evaluation? Company ACompany B Year 1Net income Cash flow $1,000,000 1,000,000 $1,000,000 0 Year 2Net income Cash flow 1,000,000 2,000,000 Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2 nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period.

Example:– Cash Flow versus Net Income ItemIncomeCash Flow Gross income (revenue$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6, ,000 -6,000 Taxable income20,000 Taxes (40%)8,000-8,000 Net income$12,000 Net cash flow$16,000

Net income versus net cash flow $0 $50,000 $40,000 $30,000 $20,000 $10,000 $8,000 $6,000 $20,000 Net income Depreciation Income taxes Operating expenses Cost of goods sold Net cash flow Gross revenue $4,000 $12,000 Net cash flows = Net income + non-cash expense (depreciation)

Corporate Taxes

Taxable Income and Income Taxes Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Item

U.S. Corporate Tax Rate (2010) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $ (  $7, (  $13, (  $22,  $113,  $3,400,  $5,150,  $6,416,  (  denotes the taxable income in excess of the lower bound of each tax bracket

Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000 Taxable incomeMarginal Tax Rate Amount of Taxes Cumulative Taxes First $50,00015%$7,500 Next $25,00025%6,25013,750 Next $25,00034%8,50022,250 Next $235,00039%91,650113,900 Next $9,665,00034%3,286,1003,400,000 Next $5,000,00035%1,750,0005,150,000 Remaining $1,000,000 38%380,000$5,530,000

Example: Corporate Income Taxes Facts: Capital expenditure$100,000 (allowed depreciation) $58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold$840,000 Depreciation $58,000 Leasing warehouse $20,000 Question: Taxable income?

Taxable income: Gross income$1,250,000 - Expenses: (cost of goods sold) $840,000 (depreciation) $58,000 (leasing expense) $20,000 Taxable income $332,000 Income taxes: First 15% $7,500 25% $6,250 34% $8,500 39% $90,480 Total taxes $112,730

Average tax rate: Total taxes=$112,730 Taxable income =$332,000 Marginal tax rate: Tax rate that is applied to the last dollar earned 39%

Disposal of Depreciable Asset If a MACRS asset is disposed of during the recovery period, Personal property: the half-year convention is applied to depreciation amount for the year of disposal. Real property: the mid-month convention is applied to the month of disposal.

Disposal of a MACRS Property and Its Effect on Depreciation Allowances

Case 1: Salvage Value < Cost Basis Gains (losses) = Salvage value – book value These gains, commonly known as either ordinary gains or depreciation recapture, are taxed as ordinary income. Most gains experienced in manufacturing environment refer to these ordinary gains. Any losses (ordinary) can be deducted from the ordinary gains from other assets first and any remaining balance can be deducted from the ordinary taxable income.

Case 2: Salvage Value > Cost Basis Gains = Salvage value – book value = (Salvage value - cost basis) Capital gains + (Cost basis – book value) Ordinary gains Capital gain is taxed as ordinary income under current tax law.

Gains or Losses on Depreciable Asset Example: A Drill press: $230,000 Project year: 3 years MACRS:7-year property class Salvage value:$150,000 at the end of Year Full Half Total Dep. = 230,000( /2) = $109,308 Book Value = 230, ,308 = $120,693 Gains = Salvage Value - Book Value = $150,000 - $120,693 = $29,308 Gains Tax (34%) = 0.34 ($29,308) = $9,965 Net Proceeds from sale = $150,000 - $9,965 = $140,035

Calculation of Gains or Losses on MACRS Property