Lecture # 8 Depreciation II

Lecture # 8
Cost Estimation 1. Depreciation part 2 2. Depletion
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Dr. A. Alim
Case Study # 1
Students will form three teams. Each team will work on the following problem: AFTER-TAX EVALUATION FOR BUSINESS EXPANSION. Blanks Book, 7th ed., Page 482 (end of chapter 17)
It is helpful to also read section 10.5 in chapter 10 of the book (page 275).
Answer questions 1 to 4 (Question 4 asks you to determine the AW of EVA)
Note that the after tax MARR is 10%.
Definition of terms when both debt and equity financing are involved: 1) Debt investment is a loan and is not included in determining the value of P. This can be readily seen for year zero: P= = = = CF out - CF in Total capital invested loan amount (loan amount + equity investment) loan amount equity investment
2) It is important to know that as a result, the rate of return on capital invested refers to return on equity investment only. A small equity investment results on a relatively large rate of return. 3) CFBT = GI E equity investment + salvage value (loan principal + loan interest) 4) Loan interest (but not principal) is tax deductible. Therefore: TI = GI E D loan interest 5) CFAT = CFBT TI(te)
Expectations from each team

The team will work as a group. Each team member must be involved in preparation and presentation.
Each team will elect a team leader (I need the team leaders names today).
Each team will make a PowerPoint presentation to the rest of the class and provide me with a copy of their presentation. Presentations will be on Tuesday, February 18, 2014. The presentation will cover: * Clear definition of the problem, what is given and what is asked * Theory and basic equations involved. * Solution strategy. * Assumptions made and sources of data needed. * Solution to the problem.
A list of the students actually presenting must be submitted at the beginning of each presentation. Students not presenting will not receive a grade for this project.
Each team is fully responsible for bringing and testing their lap tops, cables, etc.
Switching between depreciation methods

Because the DDB method may or may not reach the estimated salvage value , It is allowed in some countries and in some US states to switch to SL method near the end of the recovery period in order to reach the estimated S, and maximize tax advantage. In the US, the MACRS method is based on this logic. Starting with DDB then switching to SL with S value of zero. The goal is to maximize the present value of accumulated depreciation: PWD = Dt (P/F, i %, t)for t =1 to n
Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012
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2012 by McGraw-Hill, New York, N.Y All Rights Reserved

General rules of switching are summarized here. 1. Switching is recommended when the depreciation for year t by the currently used model is less than that for a new model. The selected depreciation Dt is the larger amount. 2. For example, switch to SL if DSL DDDB 3. Only one switch can take place during the recovery period. 4. The undepreciated amount, that is, BVt is used as the new adjusted basis to select the larger Di for the next switching decision. 5. If a value for S is given or assumed, it must be used in calculating the SL depreciation. The book value at year n can not be less than S. This makes it ALWAYS advantageous to switch to SL near or at the last year.
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Blank, 7th ed. Examples 16A.3 ( p. 433 ) , 16A.4 ( p. 435 ) Blank, 6th ed. Examples 16A.2 ( p. 559 ) , 16A.3 ( p. 562 )
(You may assume S = 0)
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Example 16A.3, part (d) is in the homework.

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Switching between depreciation methods (Application)

The MACRS method is based on a switch from DDB to SL: Applying all the rules mentioned earlier And allowing for the half year convention Reading assignment:
Read the following in Blanks book (7th ed.): Section 16A.3, page 435. Examples 16A.5 and 16A.6 illustrate how the MACRS rates are derived by applying DDB-SL switch.
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Depletion
Depreciation is applied to assets that can be replaced.
Depletion applies to resources that are not easily replaced, and are depleted with usage:
Timber,
Mineral deposits,
Oil and gas, etc.
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Two methods to calculate depletion
Cost Depletion Also called factor depletion Based upon the level of activity or usage; Time is not involved.
Percentage Depletion Applies a constant, stated percentage of the resource's gross income provided it does not exceed 50% of the firms current taxable income.
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DEPLETION: Cost Depletion

First, the cost basis of the resource is determined first cost or investment cost. Second one must estimate the amount of the resource that is available for extraction. Termed: Resource Capacity. It is an estimated value since it is impossible to predict exactly the true resource capacity! Then, cost depletion factor pt for year t is calculated If the original resource capacity is re-estimated in the future, a new pt is recalculated.
Let t denote the year

pt denotes the depletion factor for year t
Then, pt is defined as:
first cost pt resource capacity

For year t: Depletion ($) = Pt x resource amount extracted in this yea.
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DEPLETION: Cost Method Example

Example 16.5, page 428, Blank (7th ed.)
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DEPLETION: Cost depletion

Major Point for cost depletion:
There must be a reasonable estimate
of the amount of the resource that is being extracted.
For firms engaged in extraction activities the process of resource estimation is an important activity and requires expert analysis.
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Percentage Depletion
An alternative method for natural resource extraction activities
A constant stated percentage of the resources gross income may be
depleted each year so long as the calculated depletion amount does not exceed 50% of the firms net taxable income (Defined as GI E), i.e. before the depletion deduction is taken ! Allowable depletions rates are published by the IRS THEREFORE: The % depletion allowance is the smaller of the calculated amount and 50% of the net taxable income in the given year, i.e. 0.5(GI-E)
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DEPLETION: Percentage Method

Deposit Sulfur, uranium, lead, nickel , zinc Gold, silver ,copper, iron ore and geothermal deposits Oil and gas wells (varies) Coal, lignite, sodium chloride Gravel, sand, peat, stone Most other minerals Percentage
Note: Due to frequent revisions of the US Federal tax code, the analyst should always refer to the latest published rates!
22%
15% 15-22% 10% 5% 14%
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DEPLETION: Percentage Method Example

Example 16.6, page 428, Blank (7th ed.)
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Depletion Law Requirement

The current law: The law allows taking the larger of the cost depreciation and the % depreciations in a given year.
This means that one should apply both methods in
the beginning, and take the larger depreciation.
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Depletion Law Requirement (Engineering Economics, 4th ed.,Prentice Hall, 2007. By C.S.Park, example 9.11 p. 455)
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2007 by Prentice Hall, All Rights Reserved
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CHEE 5369/6369 Homework # 3 Thursday February 6, 2014 The following solved examples from Blank (7th): Example 16.1 Example 16.3 Example 16A.1 Example 16A.3(d) Example 16A.5 Example 16A.6 page 418 page 421 page 430 page 434 page 436 page 437
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Lecture # 8 Depreciation II

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Lecture # 8

Cost Estimation 1. Depreciation part 2 2. Depletion

Note that the after tax MARR is 10%.

Expectations from each team

Switching between depreciation methods

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Switching between depreciation methods

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Switching between depreciation methods

(You may assume S = 0)

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Example 16A.3, part (d) is in the homework.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Switching between depreciation methods (Application)

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Two methods to calculate depletion

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

DEPLETION: Cost Depletion

Let t denote the year

first cost pt resource capacity

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

DEPLETION: Cost Method Example

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

DEPLETION: Cost depletion

of the amount of the resource that is being extracted.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

A constant stated percentage of the resources gross income may be

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

DEPLETION: Percentage Method

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

DEPLETION: Percentage Method Example

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Depletion Law Requirement

the beginning, and take the larger depreciation.

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

2007 by Prentice Hall, All Rights Reserved

2007 by Prentice Hall, All Rights Reserved

2007 by Prentice Hall, All Rights Reserved

2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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