1. EML4550 2007 1 EML4550 - Engineering Design Methods Engineering-Economics Depreciation & Taxes Hyman, Chapter 8

2. EML4550 -- 2007 General Definitions nMarket value: The price at which consumers in the open market are willing to pay for a product or service. lGenerally, market value is less than the value to owner nBook value: an asset value minus the depreciation expense and other liabilities taken to date nDepreciation: the allowance for loss of an asset value due to age, ordinary wear and tear, degraded functionality, etc.. lHas a tax-saving consequence as a cost of doing business lTaxable income = total income - allowable expenses – depreciation lDepreciation is treated as an expense (tax deductible) lAn asset can be depreciated over a period of time with specified amount depending on the nature of the asset.

3. EML4550 -- 2007 Depreciation nStraight line: one can set aside a fixed depreciation amount of money yearly. nModified Accelerated Cost Recovery System (MACRS)MACRS lEconomic Recovery Act (1981)  ACRS lTax reform Act (1986)  MACRS §Special manufacturing devices; some motor vehicles: 3 years §Computers; trucks; semiconductor manufacturing equipment: 5 years §Office furniture; railroad track; agricultural building: 10 years §Sewage treatment plants; telephone systems: 15 years §Residential rental property: 27.5 years §Nonresidential rental property: 31.5 years

4. EML4550 -- 2007 MACRS nThe annual depreciation amount is calculated using the recovery rate q given in the table D=qC i lThe asset value is completely depreciated even though there may be a true salvage value lMACRS assumes the investment is placed at the midpoint of the initial year. Therefore, only 50% of the first year depreciation applies for tax purpose. lAs a result, a half year of depreciation be taken in year n+1

5. EML4550 -- 2007 Example nAn equipment has an initial capital cost of $10,000 and a salvage value of 2,000. The total useful period is 5 years. Compare the annual depreciation amount using either the straight line or the MACRS calculation. Straight lineMACRS 11,6002,000 (0.2) 21,6003,200 (0.32) 31,6001,920 (0.192) 41,6001,150 (0.115) 51,6001,150 (0.115) 6580 (0.058) sum8,00010,000 (1.0)

6. EML4550 -- 2007 Taxes nA financial charge by the government on a product, income or activity. lProperty taxes, sales taxes (by buyers), excise taxes (non-essential goods like tobacco, liquor), income taxes lCorporate federal graduated tax schedule (table 8.10)Corporate federal graduated tax schedule lOnly impose on taxable income after deducting operating expenses and depreciation. lIf there is a state tax, it is usually exempted from federal taxes, therefore, effective tax rate = state rate + (1- state rate) (federal rate) Total Income Operating Expenses Depreciation Taxable Income Taxes

7. EML4550 -- 2007 Example A company earns a gross income of $10M. Operating expenses are estimated at $6M and depreciation is $1.5M. (a) Determine the average federal income taxes w/o state taxes; (b) assume the state tax rate is 7%, what is the effective tax rate? (a) Net income=10 - 6 - 1.5=$2.5M Taxes=(50,000)(0.15)+(25,000)(0.25)+(25,000)(0.34)+(235,000)(0.39) +(2,500,000-335,000)(0.34)=7,500 +6,250+8,500+91,650+736,100=$850,000 average tax rate=850,000/2,500,000=0.34 (b) Effective tax rate = 0.07 + (1 – 0.07)(0.34) = 0.40

8. EML4550 -- 2007 Example For motor A Depreciation: 2 nd yr  - 9.6 Tax benefit @0.34  - 3.26 (-3.26)[P/F] 0.2, 2 =(-3.26)(0.694)=-2.26 this can be deducted as expenses thus decreasing present value of motor A. Next page

9. EML4550 -- 2007 Example (cont.) for motor A maint.+elect  operating expenses=2.99+9.75=12.74 tax benefit @0.34  -4.33 Productivity benefit+salv.= -1.5-1.61=-3.11 This can be considered income to the company  need to pay income taxes @0.34 (3.11)(0.34)=1.06 It is positive since we over- estimate the benefit by not considering income taxes previously. We need to add this to the expense category for the motor

10. EML4550 -- 2007 Inflation nConsumer Price Index (CPI): a composite price index to measure average change over time in the prices paid by urban consumers for a market basket of consumer goods and services such as food, shelter, transportation, apparel, etc..Consumer Price Index (CPI): l1982-1994: 3.33%, 1994-2004: 2.59% nProducer Price Index (PPI): this program measures the average change over time in the selling prices received by domestic producers for their output.Producer Price Index (PPI): lCommodity classificationCommodity §Finished goods (ex. Automobiles, TV) §Intermediate materials, supplies (ex. Flour, steel products, lumber, etc..) §Crude materials (ex. Grains, livestock, crude oil, coal, etc..) lIndustrial classification §Air transportation, power, grocery, etc..

11. EML4550 -- 2007 Real Discount Rate nDue to annual inflation, the real value (purchasing power) of the money will be decreased accordingly. This reduction can effectively change the real investment rate (interest rate) as: nIf we assume the average annual inflation rate is f=0.03, then the nominal interest rate of 20%=0.2 will need to be modified to get the real discount rate nIf the inflation rate is small, then i real  i nom – f=0.2-0.03=0.17 (about 3% difference w.r.t. 0.165)