1. Engineering Economic Analysis
Chapter 11
DEPRECIATION

2. Basic Aspects of Depreciation
An important component in computing income taxes.
For tax purposes:
Depreciation is the systematic allocation of the cost of an asset spread over its depreciable life.
Companies pay income taxes based on their taxable income. The taxes paid are a cash cost, so it is in the realm of engineering economic analysis. Everything we have done so far is on a pre-tax basis.

3. Taxable Income Taxable income is defined to be:
We need to consider after-tax reality, income tax is paid on taxable income, which is the companies gross income minus all of their expenditures that are not depreciable minus all depreciation and depletion charges

4. 3 ways to categorize business expenditures
Expenditures for depreciable assets
Facilities or productive equipment with a useful lives longer than one year
Costs are allocated over time
2. Expenditures for non-depreciable assets
All land purchased for business & items not used either in trade, business, or for production of income
Some things, like natural resources are subject to depletion
3. All other business expenditures
Labor
Material
Assets with useful lives of less than one year
These items are expensed, written off in full in the same year
These first two expenditures are capital expenditures. The last are taken directly out of the gross income and are called “ordinary and necessary expenditures.” When we analyze engineering projects we need to know the income tax impacts. For ordinary and necessary expenditures, this is an easy task, because they reduce taxable income directly, so we can analyze the impacts. For capital expenditures we need to determine how they are allocated through depreciation and depletion. Written off over time.

5. Depreciation In an economic context In an accounting context
Definition: A decrease in value
Market value
Value to the owner
In an accounting context
Definition: a systematic allocation of the cost of an asset over its depreciable life. Related to
Deterioration
Obsolescence
There are multiple definitions of depreciation:
Decrease in value to owner
Decrease in value to the market
These are economic definitions of depreciation and are due to obsolescence or deterioration
Systematic allocation of the cost of an asset over its useful or depreciable life
This is an accounting definition, which is the one that impacts income taxes, so it is the one we will use

6. A Property is Depreciable If
The property is used for business purposes in the production of income.
The property has a useful life that can be determined, and the useful life is longer than one year.
The property decays, gets used up, wears out, becomes obsolete or loses value from natural causes.

7. Depreciation for Tax Purposes
Depreciable life: the period over which an asset is depreciated (recovery period).
Depreciation is a non-cash cost: money does not change hands during the recovery period.
Depreciation is used to allocate an asset’s loss of value over time.
Depreciation is deducted from revenue and reduces the taxable income of a business over time.
Depreciation is a cash flow on an after tax-basis.

8. Classification of Property
Tangible: can be seen, touched, and felt.
Real: land, buildings, and things growing on, or attached to the land
Personal: equipment, furnishings, vehicles, office machinery, or not defined as real property
Intangible: has value but cannot be seen or touched, examples include patents, copyrights, and trade marks.
In general, buildings and equipment are depreciable; land is not.

9. Depreciation Calculation
The cost basis is the cost to buy/acquire asset and get it ready to use
examples:
Installation costs
Tooling costs
di is the depreciation take in year i

10. Depreciation Methods Historical methods
Straight line
Sum-of-years digits
Declining balance
Declining balance switching to straight line
Modified accelerated cost recovery system
Over the years the US Government has used each of these systems in turn to determine allowable depreciation for tax purposes. MACRS is now the system used for most depreciable property.

11. Straight Line Depreciation
With Straight line depreciation dt is a constant amount

12. Example 1
A piece of machinery costs $12,000, has a salvage value of $600, and has a useful life of 5 years. What is the yearly depreciation amount using straight line depreciation?
B=$12,000
S=$600
N = 5
Yearly depreciation is ($12000-$600)/5 =$2280

13. Sum-Of-Years Digits Depreciation
SOYD = Sum-of-years digits

14. Example 2: SOYD Depreciation for the same data as Example 1

15. Example 2: Table of the Book values
Year, t
Depreciation in year t, dt
Σdi
Book Value in year t,
BVt = B - Σdi $0
$12,000 = B 1
$3,800
$8,200 2
$3,040
$6,840
$5,160 3
$2,280
$9,120 4
$1,520
$10,640
$1,760 5
$760
$11,400
$600 = S

16. Declining Balance Depreciation
Applies a constant depreciation rate to the book value
Common rates include
200% → Double declining balance method
150%

17. Example 3
A piece of machinery costs $12,000, has a salvage value of $600, and has a useful life of 4 years. Find the depreciation schedule using double declining balance depreciation.

18. Depreciation in year t, dt
Example 3
Year, t
Depreciation in year t, dt
Σdi
Book Value in year t,
BVt = B - Σdi $0
$12,000 = B 1
$4,800
$7,200 2
$2,880
$7,680
$4,320 3
$1,728
$9,408
$2,592 4
$1,036.80
$10,444.80
$1,555.20 5
$622.08
$11,066.88
$ ≠ S

19. Example 3 Notice that BV5 ≠ S
Need to modify this so that we depreciate all the way to the salvage value
To do this we use the Modified Accelerated Cost Recovery System (MACRS)

20. MACRS Modified Accelerated Cost Recovery System
MACRS is the system presently used by the US government.
General Method (IRS FORM 4562):
Determine item cost
Determine item property class
Use table to find percent depreciation
Multiply percentage by cost
The US tax code requires that many special issues be considered beyond the general view presented here.

21. Advantages of MACRS There are several advantages to using MACRS:
Uses property class lives that are shorter than useful lives
Each asset is placed into a property class
Recovery period is based on the property class
Salvage values are assumed to be $0
Get more money depreciated
Tables of percentages tell what percent of B to depreciate each year
Calculation is more simple

22. MACRS There are two systems MACRS uses to calculate depreciation:
GDS – General depreciation system
Based on declining balance with a switch to straight line depreciation
Default depreciation calculation for MACRS
ADS – Alternative depreciation system
Based on straight line with longer depreciation period
To use MACRS, need to know the following things:
Cost Basis
Property Class
Recovery Period
When asset is placed in service

23. How to determine property class: (Go down this list in order)
Property class is given in problem
Asset is named in Table 11-2
Use IRS tables or table 11-1
Class life
Use 7-year property class for “all other property not assigned to another class”

24. Once you know the property class we can find the yearly depreciation amount, dt:

25. MACRS MACRS depreciation assumptions
Salvage values is $0 for all assets
Declining balance is 200% for 3, 5, 7, 8, and 10 year property and 150% for 15 and 20 year property
The asset is placed into service at 6 months in 1st year and is taken out of service at 6 months in (n+1)th year, except real property which uses the actual month in which the asset is placed in service

26. Example 4
A new machine tool is being purchased for $76,000 and is expected to have a zero salvage value at the end of its five year useful life. Using MACRS depreciation method compute the depreciation table for this asset.

27. Example 4 – Yearly Depreciation Table
5 year property from Problem
Same as above
Assume at 6 month of 1st year
Year
rt · B = dt 1
20% · $76,000 = $15,200 2
32% · $76,000 = $24,320 3
19.2% · $76,000 = $14,592 4
11.52% · $76,000 = $8,755.20 5
11.52% · $76,000 = $ 8,755.20 6
5.76% · $76,000 = $4,377.60

28. Example 4 – Depreciation Table
Year dt
Σdi
BVi 1
$15,200
$60,800 2
$24,320
$39,520
$36,480 3
$14,592
$54,112
$21,888 4
$8,755.20
$62,867.20
$13,133.80 5
$71,622.40
$4,378.60 6
$4,377.60
$76,000 $0

29. Example 5
A hotel resort is bought in April 1995 for $2.0 million for the hotel and $0.5 million for the grounds. The resort (& land) is sold in August Calculate the depreciation Schedule for years What is the book value in year 6 when the real estate was sold?

30. Example 5 This is a real estate situation
The grounds do not depreciate
The resort depreciates as non-residential property
We use table 11-4
Need to determine the four things needed
B = $2.0 million
Non-residential property
39 years
April (month 4)

31. Example 5 – Yearly Depreciation Tabledt 1
1.819% · $2,000,000 = $36,380 2
2.564% · $2,000,000 = $51,280 3 4 5 6
1.605% · $2,000,000 = $32,100

32. Example 5 – Depreciation Table
Year di
Σdi
BVi 1
$36,380
$1,967,900 2
$51,280
$87,660
$1,931,520 3
$138,940
$1,880,240 4
$190,220
$1,828,960 5
$241,500
$1,777,680 6
$32,100
$273,600
$1,726,400
Therefore the book value in year six is $1,726,400

33. Depletion
Exhaustion of natural resources due to their removal, examples include:
Oil
Coal
Wood
Minerals

34. Depletion There are two methods to calculate depletion:
Cost depletion
Percentage depletion
Usually, use larger value from both methods
Except for standing timber, oil & gas, then use cost depletion
Compute the depletion allowance
Cost depletion:
Where B is the cost of the depletable asset and S is the salvage value

35. Example 6
Some land with standing timber cost $35,000, $5,000 for the land and $30,000 for the timber. It has an estimated 1.5 million board-feet of lumber. If 100,000 board-feet of lumber is cut in 1 year, what is the depletion allowance?

36. Percentage Depletion Allowance is a certain percent of gross income
Must be less than 50% of taxable income without depletion allowance
Can be greater than property cost
Each kind of deposit has a percentage for tax purposes (Table 11-6)

37. Example 7
A coal mine has a gross income of $250,000 per year. Mining expenses were $210,000. Find the percentage completion allowance (in dollars).

38. Example 7 From the table, the percent allowance is 10%
Find the computed percentage depletion allowance is:
Compare to 50% of the taxable income
50% of the taxable income is $20,000

39. Example 7
We need to find the minimum of the calculated depletion allowance and 50% of the taxable income:
Percentage depletion allowance is $20,000