1. (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Repairs or Improvements to Depreciable Assets

2. (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. 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

3. (c) 2001 Contemporary Engineering Economics 3 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation

4. (c) 2001 Contemporary Engineering Economics 4 Factors to Consider in Asset Depreciation What is the depreciable life of the asset? What is asset’s value at the end of its useful life? What is the cost of the asset? What method of depreciation we choose?

5. (c) 2001 Contemporary Engineering Economics 5 What Can Be Depreciated? 1. Assets used in business or held for production of income 2. Assets having a definite useful life and a life longer than one year 3. Assets that must wear out, become obsolete or loses value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land?

6. (c) 2001 Contemporary Engineering Economics 6 Example 10.1 Cost Basis Cost of new hole-punching machine (Invoice price) $62,500 + Freight725 + Installation labor2,150 + Site preparation3,500 Cost basis to use in depreciation calculation $68,875

7. (c) 2001 Contemporary Engineering Economics 7 Asset Depreciation Ranges – ADR (years) Assets UsedLower LimitMidpoint LifeUpper Limit Office furniture, fixtures, and equipment 81012 Information systems (computers) 567 Airplanes 567 Automobiles, taxis 2.533.5 Buses 7911 Light trucks 345 Heavy trucks (concrete ready-mixer) 567 Railroad cars and locomotives 121518 Tractor units 567 Vessels, barges, tugs, and water transportation system 14.51821.5 Industrial steam and electrical generation and or distribution systems 17.52226.5 Manufacturer of electrical and nonelectrical machinery 81012 Manufacturer of electronic components, products, and systems 567 Manufacturer of motor vehicles 9.51214.5 Telephone distribution plant 283542

8. (c) 2001 Contemporary Engineering Economics 8 Types of Depreciation Book Depreciation Method –Used in reporting net income to investors and stockholders –Used in pricing decision Tax Depreciation Method –Used in calculating income taxes for the IRS –Used in engineering economics

9. (c) 2001 Contemporary Engineering Economics 9 Book Depreciation Methods Purpose: Used to report net income to investors and stockholders. Types of Depreciation Methods: Three different methods can be used to calculate the periodic depreciation allowances for financial reporting. –Straight-Line Method –Declining Balance Method –Units of Production Method

10. (c) 2001 Contemporary Engineering Economics 10 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion (equal amount of service) in each year over its life. Formula Annual Depreciation D n = (I – S) / N Where D n = Depreciation charge during year n Book Value B n = I – n (D) where I = cost basis S = Salvage value N = depreciable life

11. (c) 2001 Contemporary Engineering Economics 11 Example 10.3 – Straight-Line Method 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 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n Annual Depreciation Book Value

12. (c) 2001 Contemporary Engineering Economics 12 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% DB or double declining balance method.

13. (c) 2001 Contemporary Engineering Economics 13 Example 10.4 – Declining Balance Method n012345n012345 D n $4,000 2,400 1,440 864 518 B n $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value

14. (c) 2001 Contemporary Engineering Economics 14 Example 10.5 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 (I) $10,000 Salvage Value (S) 0 Depreciation200% DDB Depreciable life (N)5 years

15. (c) 2001 Contemporary Engineering Economics 15 n Dn Depreciation Book Value 1234512345 10,000(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 1,296 778 n Dn Book Depreciation Value 1234512345 4,000 $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 > 518 0 (a) DDB 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. 4 th year switch to SL Case 1: S = 0 Example 10.5

16. (c) 2001 Contemporary Engineering Economics 16 Case 2: S = $2,000 Example 10.6 End of YearDepreciation (D n )Book Value (B n ) 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 > 1602160 – 160 = 2,000 Adjusting to salvage value 50 Total = $8,000 2,000 – 0 = 2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.

17. (c) 2001 Contemporary Engineering Economics 17 Units-of-Production Method Example 10.8 Principle The number of service units will be consumed in that period. Formula Depreciation in any year is given by D n = Service units consumed for year n total service units (I - S)

18. (c) 2001 Contemporary Engineering Economics 18 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, DB, SOYD*) Assets placed in service from 1981 to 1986 Use Accelerated Cost Recovery System (ACRS) Table Assets placed in service after 1986 Use Modified ACRS Table or MACRS

19. (c) 2001 Contemporary Engineering Economics 19 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property ( includes assets such as machinery, vehicles, equipment, furniture, and similar items) Depreciation method based on DB method switching to SL Half-year convention Zero salvage value Real Property ( land and generally anything that is erected on, growing on, or attached to land ) SL Method Mid-month convention Zero salvage value

20. (c) 2001 Contemporary Engineering Economics 20 MACRS Property Classifications Recovery PeriodADR Midpoint ClassApplicable Property (8 categories of assets) 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. 27.5-yearResidential rental property 39-yearNonresidential real property including elevators and escalators

21. (c) 2001 Contemporary Engineering Economics 21 MACRS Table

22. (c) 2001 Contemporary Engineering Economics 22 Example 10.9 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% $2000 32% $3200 Full 19.20% $1920 Full 11.52% $1152 Full 11.52% $1152 Full 5.76% $576 123 4 5 6 Half-year Convention

23. (c) 2001 Contemporary Engineering Economics 23 Year (n) 1 2 3 4 5 6 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)(28.80%)11.52% SL = (1/1.5)(100-82.72%)11.52% SL = (0.5)(11.52%)5.76% MACRS (%) DDB SL

24. (c) 2001 Contemporary Engineering Economics 24 Conventional DB Switching to SL MACRS with half-year convention 2,0003,2001,9201,1521,152576 4,0002,4001,4401,0801,080

25. (c) 2001 Contemporary Engineering Economics 25 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D 1 = (9.5/12)(100%/27.5) = 2.879%

26. (c) 2001 Contemporary Engineering Economics 26 Example 10.13 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties.