DEPRECIATION

AND
INFLATION
Depreciation
• Depreciation is an accounting method of allocating the cost of
a tangible asset over its useful life. Businesses depreciate long
term assets for both tax and accounting purposes. For tax
purposes, businesses can deduct the cost of the tangible asset
they purchase as business expenses.
• In other words the depreciation is a gradual degradation in asset
value from any reason.
• depreciable assets are machines, plants, furniture, buildings,
computers, trucks, vans, equipment, etc.
Tangible asset
• Tangible assets include both
1. fixed assets, such as machinery, buildings and land.
2. current assets, such as inventory, furniture,… etc.

The opposite of a tangible asset is an intangible asset.

Nonphysical assets, such as patents, trademarks, copyrights,
goodwill and brand recognition, are all examples of intangible
assets.
Nature of depreciation
1. Depreciation is decline in the book value of fixed assets.
2. Depreciation includes loss of value of assets due to passage of
time, and usage.
3. Depreciation is a continuing process till the end of the useful
life of assets.
4. Depreciation is an expired cost and hence must be deducted
before calculating taxable profits.
Methods of determining depreciation
1. Straight line method
Depreciation using the straight line method reflects the consumption of the
asset over time and is calculated by subtracting the salvage value from
the purchase price of the asset, and then dividing that amount by the projected
useful life of the asset. For instance, say a catering company purchases a
delivery van for $35,000. The expected salvage value is $10,000 and the
company expects to use the van for five years. By using the formula for the
straight line method, the annual depreciation is calculated as

Depreciation = (Cost – salvage value) / Useful life

(35,000 - 10,000) / 5 = 5,000.

The van depreciates at a rate of $5,000 per year for the next five years.
Straight line method
the asset is purchased on a date other
• In the event
than the beginning of the year, the straight line
method formula is multiplied by the fraction of months
remaining in the year of purchase. In the above example, if the
van was purchased on Oct. 1, depreciation is calculated as
• (3 months / 12 months) x {(35,000 - 10,000) / 5} = 1,250.
• In the first year, the catering company writes off $1,250.
Straight line method
• Example: On April 1, 2011, Company (A) purchased an
equipment at the cost of $140,000. This equipment is estimated
to have 5 year useful life. At the end of the 5th year, the salvage
value (residual value) will be $20,000. Company (A)
recognizes depreciation to the nearest whole month. Calculate
the depreciation expenses for 2011, 2012 and 2013 using
straight line depreciation method.
Solution
• Depreciation for 2011
= ($140,000 - $20,000) x 1/5 x 9/12 = $18,000

Depreciation for 2012, 2013

= ($140,000 - $20,000)/ 5= $24,000
Example
• Consider a machine purchased for $10,000 with an estimated
life of five years and estimated salvage value of 2000$.
Calculate the depression using straight line method.
Solution
Example
Decline method
• Under this method, the amount of depreciation is calculated as a
fixed percentage of the reducing or diminishing value of the
asset standing in the books at the beginning of the year, so as to
bring down the book value of the asset to its residual value.
• The amount of depreciation goes on decreasing every year. That
is, the amount of depreciation charged in each period is not
fixed but is a gradually decreasing sum

𝑛 𝑠𝑙𝑎𝑣𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
• Depreciation rate= 1 −
𝑖𝑛𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡
Example 4 : From the following information you are required to calculate depreciation
rate under decline Method.

𝑛 𝑠
𝑟 = (1 − ) ∗ 100%
𝑐

3 1000
𝑟 = (1 − ) ∗ 100%=53.6%
10000

-
n Dn Bn

0 - 10000

1 5360 4640

2 2487 2153

3 1153 1000
Double decline method
• Double declining balance depreciation method is a type of
declining balance depreciation method in which depreciation
rate is double the straight-line depreciation rate.

• While computing this rate two thinks have to be kept in the

mind:
1. No allowance is to be made for salvage value of asset.
2. The total cost should not be reduced by charging the
depreciation to amount less than salvage value
Example
Solution
• The book value at the beginning of the first year is $10,000 and the
declining- balance rate a is 200% (1/5) = 40%

• in year 4, B4 would be less than S = $2,000 if the full deduction

($864) is taken. Tax law does not permit us to depreciate assets below
their salvage value therefore, we adjust D4 to $160, making B4 =
$2,000. D5 is zero, and B5 remains at $2.000. The following table
provides a summary of these calculations:
Example 5
Sum of Years Digits method
• This method also termed as SYD Method. The Sum of years
Digits Method is designed on the basis of decline Method.
Under this method the amount of depreciation to be charged to
the Profit and Loss Account goes on decreasing every year
throughout the life of the asset. The formula for calculating the
amount of depreciation is as follows :
Example 6
Units of production method
Example
Definition of inflation
• Inflation is defined as an increase in the amount of money
required to purchase or acquire the same amount of products
and services that was acquired without its effect. Inflation
results in a reduction in the purchasing power of the monetary
unit. In other words, when prices of the products and services
increase, we buy less quantity with same amount of money i.e.
the value of money is decreased. For example, the quantity of
items we purchase today at a cost of $1000 is less than that was
purchased 5 years ago. This is due to a general change
(increase) in the price of the goods and services with passage of
time.
Effect of inflation on interest rate
1. real interest rate (i) : the interest rate ‘i' that was used in the economic
evaluation of a single alternative or between alternatives by different
methods as mentioned in earlier lectures was assumed to be inflation-free
i.e. the effect of inflation on interest rate was excluded. This interest
rate ‘i' is also known as also real interest rate or inflation-free interest
rate. It represents the real gain in money of the cash flows with time
without the effect of inflation.

2. Inflation rate (f): the amount of increase in the prices

3. market interest rate (ic): if inflation is there in the general market, then
effect of inflation on the interest rate needs to be taken into account for
the economic analysis. The interest rate that includes the effect of price
inflation which is occurring in general economy is known as the market
interest rate (ic). It takes into account the adjustment for the price
inflation in the market. Market interest rate is also known as inflated
interest rate or combined interest rate as it combines the effect of both
real interest rate and the inflation.
Monetary units
The monetary units can be Rupees, Dollars, Euros, Dinars etc.
There are two parameters while considering the effect of inflation in the cash
flow of the alternatives.
1. The actual monetary units are also referred as future or inflated monetary
units. The purchasing power of the actual monetary units includes the
effect of inflation on the cash flows at the time it occurs.
2. The constant value monetary units are also called as real or inflation-free
monetary units. The constant value monetary units are expressed in terms
of the same purchasing power for the cash flows with reference to a base
period. Mostly in engineering economic studies, the base period is taken
as ‘0' i.e. now. But it can be of any time period as required.
Example 1:
• The present (today's) cost of an item is Rs.20000. The inflation
rate is 5% per year. How does the inflation affect the cost of the
item for the next five years?
The relationship between constant and actual
value Monterey units
From above table, the relationship between cost in actual monetary
units (inflated) in time period ‘n‘ and cost in constant value monetary
units (inflation-free) can be represented as follows;

From equation above, the expression for cost in constant value

monetary units (inflation-free) is written as follows
Future worth without inflation
• The relationship between present worth and future worth
considering the time value of money is given by;
Equivalent worth calculation including the
effect of inflation
• future worth in constant value monetary units (inflation-free)
can be represented in terms of future worth in actual monetary
units (inflated) by using the relationship stated in equation.
Equation can be rewritten by including the inflation rate.
Compound interest rate

The expression in the above equation that combines the effect

of real interest rate ‘i‘ and inflation rate ‘f ' is termed as combined interest rate or
market interest rate (ic) as stated earlier.
Modification of factors
• the relationship between annual worth ‘ A ' and present worth ‘ P ' and that
between ‘A' and future worth ‘F' of the cash flows considering the effect of
inflation can be obtained by replacing i with ( ic ) in each
factor.

• For example A to P (P/A, i%, n) 1+𝑖𝑐 𝑛−1

𝑖𝑐 1+𝑖𝑐 𝑛
Real interest & combined interest
From known values of combined interest rate ‘ic' and
inflation rate ‘f' , the real interest rate ‘ i' can be
obtained from previous equation and is given as
follows;
Example 2
• A person has now invested Rs.500000 at a market interest rate
of 14% per year for a period of 8 years. The inflation rate is 6%
per year.

1. What is the future worth of the investment at the end of 8

years?

2. What is the accumulated amount at the end of 8 years in

constant value monetary unit i.e. with the same buying power
when the investment is made?
Solution
• The market or combined interest rate per year ( ic) and inflation rate
per year (f) are 14% and 6% respectively.
• i) The future worth i.e. amount of money accumulated at the end of 8
years will include the effect of inflation and the interest amount
accumulated will be calculated using market or combined interest
rate.

• Putting ‘ P' , ‘ic', ‘n' equal to Rs.500000, 14% and 8 years respectively
in the above expression;

• Thus the future worth of the investment at the end of 8 years in actual
monetary unit (inflated) is Rs.1426300.
Solution
Solution
The future worth of the investment with same buying power as now i.e. when the
investment is made can also be calculated by using the real interest rate. The real
interest rate can be calculated from market interest rate and inflation rate using
equation
Example 3
The cash flow of an alternative consists of payment of
Rs.100000 per year for 6 years (uniform annual series). The real
interest rate is 9% per year. The inflation rate per year is 5%.
Find out the present worth of the uniform series when the annual
payments are in actual monetary units (inflated).
Solution
• For determination of present worth of the uniform annual series payment,
which is in actual monetary units (inflated), first the combined interest
rate (ic) is calculated from the known values of real interest rate (i ) and
inflation rate (f ) using equation
Taxes
• The calculation of income taxes is based on taxable income of
the firm and the income tax to be paid by a firm is equal to
taxable income multiplied with the applicable income tax rate.
The taxable income is calculated at the end of each financial
year. For obtaining the taxable income, all allowable expenses
(excluding capital investments) and depreciation cost are
subtracted from the gross income of the firm. It may be noted
here that depreciation is not the actual cash outflow but it
represents the decline in the value of the asset (depreciable) and
is considered as an allowable deduction for calculating the
taxable income. The taxable income is also known as net
income before taxes. The net income after taxes is obtained by
subtracting the income taxes from taxable income (i.e. net
income before tax)
Taxes expression
• The expression for taxable income is shown below.

The income tax to be paid is calculated as a percentage of the taxable income

and is given as follows;
Example 4
For a given financial year, the gross income of a construction contractor is
Rs.11530000. The expenses excluding the capital investment and the
depreciation are Rs.4170500 and Rs.2080000 respectively. Calculate the
taxable income and income tax for the financial year with the following
assumed marginal tax rates for different taxable income ranges.
Solution
For the financial year, the taxable income of the construction
contractor is calculated using the expression stated earlier.

The income tax will be equal to the sum of income taxes calculated over the t
axable income ranges at the specified tax rates. The construction contractor
will pay 10% on first Rs.1000000 of taxable income, 20% on next Rs.2000000
(i.e. Rs.3000000 – Rs.1000000) of taxable income, 30% on next Rs.2000000
(i.e. Rs.5000000 – Rs.3000000) of taxable income and 35% on the remaining
Rs.279500 (Rs.5279500 – Rs.5000000) of taxable income.
The taxable income and income tax for the financial year are Rs.5279500 and
Rs.1197825 respectively. For the construction contractor with the above
taxable income, the average tax rate fore the financial year is calculated as
follows;
US corporate taxes
Example 5