UNIVERSITY OF LA SALETTE,INC

COLLEGE OF ENGINEERING AND ARCHITECTURE

SANTIAGO CITY, PHILIPPINES

Module 6: Depreciation and After-Tax Economic Analysis

Introduction
CFAT after taxes is a measure of cash flow that takes into account the impact of taxes on profits.
This measure is used to determine the cash flow of an investment or project undertaken by a corporation.
To calculate the after-tax cash flow, depreciation must be added back to net income. Depreciation is
a non-cash expense that represents the declining economic value of an asset but is not an actual cash
outflow. 
In this module we will be learning depreciation, depletion, capital cost and annual cost which can
help us understand cost of a productive asset and the revenues earned by using the asset. 

Learning Outcomes
At the end of this module, you are expected to:
a. solve problems involving depletion
b. illustrate project alternatives by applying depreciation select the most economically
efficient one; and
c. calculate annual cost and capitalized cost.
Preassessment:
On the last module we tackled about economic problems which deals with bonds, arithmetic and
geometric gradient, in connection with this calculate the following problems. (write your solution on the
attached sheet at the back of this module):
1. A P2000 8% bond pays divided semiannually and will be redeemed at 105% on June 21, 2004. It
is bought on June 21, 2001 to yield 5% interest. Find the price of the bond.
2. The Texas Highway Department expects the cost of maintenance for a particular piece of heavy
equipment to be $5000 in year 1, $5,500 in year 2, and amounts increasing by $500 through year
10. At an interest rate of 10% per year, what is the present worth of the maintenance cost?

Lecture
Topic 1: Depreciation
Depreciation means the decrease in the value
of physical properties or assets with the passage of
time and use. It is the non-cash method of representing
the reduction in value of a tangible asset.
Specifically, it is an accounting concept that
sets an annual deduction considering the factor of time
and use on an asset's value. An asset is depreciable if it
has a determinable useful life of more than one year in
business or something to produce an income.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
1
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Types of Depreciation Method

1. Straight Line Method is the simplest depreciation method.
It assumes that a constant amount is depreciated each year
over the useful life of the property.

The formulas for Straight Line Method are:

( FC −SV )
Annual Depreciation =
n
[(FC −SV )(5)]
Total Depreciation after five years =
n
Book Value = FC - Total Depreciation

Example

A commercial building has a salvage value of Php 1 million after 50 years. Annual depreciation is Php 2
M. Using the Straight Line Method, how many years after should you sell the building for Php 30 M?

Solution
a. Solve for the first cost.
( FC −SV )
Annual depreciation =
n
( FC −1 M )
2=(
50
FC = Php 101 million

b. Solve for the total depreciation after n years.

Total depreciation = FC – BV
Total depreciation = 101M – 30M
Total depreciation = 71 million

c. Solve for the number of years.

Total depreciation = Annual depreciation (n)
71 = 2 (n)
n = 35.5 years ans.

2.Declining Balance Method is sometimes called the Constant-

Percentage Method or the Matheson formula. The assumption
in this depreciation method is that the annual cost of
depreciation is the fixed percentage (1 - K) of the Book Value
(BV) at the beginning of the year. The formulas for Declining
Balance Method of Depreciation are:

 Annual Rate of Depreciation(K): SV = FC (1 - K)n

 Book Value = FC (1 - K)m
 Depreciation at mth year = FC (1 - K)m-1 (K)

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
2
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

 Total Depreciation = FC - SV

Example
The equipment bought at a price of Php 450,000 has an economic life of 5 years and a salvage
value of Php 50, 000. The cost of money is 12% per year. Compute the first-year depreciation using
Declining Balance Method.

Solution
a. Solve for the annual rate of depreciation.
SV = FC (1 - K)n
50,000 = 450,000 (1 - K)5
K = 0.356

b. Solve for the depreciation at the end of the first year.

Depreciation = (K) (FC) (1 - K)(m-1)

Depreciation = (0.356) (450,000) (1 - 0.356)0
Depreciation = Php 160,200

3. Sum of the Years Digit Method is an accelerated depreciation technique based on the
assumption that tangible properties are usually
productive when they are new, and their use
decreases as they become old.

The formulas for the Sum of the Years Digit Method of

Depreciation are:
n
 Sum of years = ( ) (n + 1)
2
 Annual depreciation at 1st year= (FC - SV)

( n
∑ of years )
 Annual depreciation at 2nd year = (FC -SV)

( (n−1)
∑ of years )
 Book Value = FC – Total depreciation at the end of nth year

Example

An equipment costs Php 1,500,000. At the end of its economic life of five years, its salvage value
is Php 500,000. Using Sum of the Years Digit Method of Depreciation, what will be its book value for the
third year?

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
3
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Solution
a. Solve for the sum of years.
5
Sum of years = ( ) (5 + 1)
2
Sum of years = 15 years
b. Solve for the total depreciation up to the third year.
5+4 +3
Total depreciation = (FC - SV) ( )
15
Total depreciation = (
1500000−500000(12)
15 )
Total depreciation = Php 800,000

c. Solve for the book value in the third year.

Book Value = FC - Total depreciation
Book Value = 1,500,000 - 800,000
Book Value = Php 700,000 ans.

4. Sinking Fund Method is a depreciation method wherein funds will accumulate for replacement
purposes.

The formulas for Sinking Fund Method of Depreciation are:

 Annual depreciation (A) = ¿
 Total depreciation after x years = A ¿
 Book Value = FC – Total depreciation

Example
A machine costs Php 300,000 with a salvage value of Php 50,000 at the end of its life of 10 years.
If money is worth 6% annually, use Sinking Fund Method and determine the depreciation at the 6th year.

Solution

a. Solve for the annual depreciation.

Annual depreciation (A) = ¿
A=¿
A = Php 18966.98956

b. Solve for the depreciation in the 6th year.

Total depreciation after x years = A ¿
Total depreciation = (18966.98956) ¿
Total depreciation = Php 132,300.7939

5. Working Hours Method also called as Service Output Method is a depreciation method
that results in the cost basis allocated equally over the expected number of units produced
during the period of tangible properties. The formula for Working Hours Method of
Depreciation is:

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
4
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

( FC −SV )
Depreciation per hour =
Total number of hours

Example

A machine costs Php 400,000 with a salvage value of Php 200,000. Life of it is six years. In the
first year, 4000 hours. In the second year, 6000 hours and 8000 hours on the third year. The expected flow
of the machine is 38000 hours in six years. What is the depreciation at the end of the second year?

Solution
a. Solve for the depreciation per hour.
( FC – SV )
Depreciation per hour =
Total number of hours
¿
Depreciation per hour = (400,000−20,000)¿
38000
Depreciation per hour = Php 10

b. Solve for the depreciation at the end of 2nd year.

Depreciation = 10 (6000)
Depreciation = Php 60,000 ans.

6. Constant Unit Method is the same with Working Hours Method in the structure of the
formula.
The formula for Constant Unit Method of Depreciation is:
(FC −SV )
Depreciation per unit =
Total number of units
Example

A coin machine costing Php 200,000 has a salvage value of Php 20,000 at the end of its economic
life of five years. Determine the annual reserve for depreciation for the third year only. The schedule of
production per year is as follows:

Solution

a. Solve for the total number of coins.

Total number of coins = 100,000 + 80,000 + 60,000 + 40,000 +20,000
Total number of coins = 300,000
b. Solve for the depreciation per unit.
(FC −SV )
Depreciation per unit = (
Total number of units

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
5
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

(200000−20000)
Depreciation per unit =
300000
Depreciation per unit = 0.60
c. Solve for the depreciation reserve for the third year.
Depreciation = 0.66 (60,000)
Depreciation = Php 36,000 ans.
Topic 2: Depletion

Depletion cost is the reduction of the value of certain natural resources such as mines, oil,
timber, quarries, etc. due to the gradual extraction of its contents.

Methods of Computing Depletion Charge for a year:

A. Unit or Factor Method

This method is dependent on the initial cost of the property and the number
of units in the property. The depletion charge during any year is calculated
using the following formula:

initial cost of property

Depletion cost during any year = (units sold during the year )
total units∈ property
B. Percentage or Depletion Allowance Method

The depletion charge under this method, is computed as follows:

Depletion Charge = Fixed Percentage of Gross Income

or 50% of the Net Taxable Income

Note: Use the smaller depletion change

Fixed percentages allowed for Certain Natural Resources:

Natural Resources Maximum Percentage

Sulfur, Cobalt, Lead, Nickel, Zinc, etc 22
Oil and Gas wells 22
Gold, Silver, Copper, Iron ore 15
Coal, Sodium Chloride 10
Gravel, Sand, Clay 5

: Based on Gross Income

Example
The Saudi Arabian Oil Refinery developed an oil well which is estimated to contain 5,000,000
barrels of oil at an initial cost of $ 50,000,000. What is the depletion charge during the year where it
produces half million barrels of oil? Use Unit or Factor method in computing depletion.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
6
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Solution
$ 50,000,000
Unit depletion rate =
5,000,000
Unit depletion rate = $ 10.00 per barrel
Total depletion during the year = (500,000)(10)
Total depletion during the year = $ 5,000,000 ans.

Topic 3: Capitalized Cost and Annual Cost

Capitalized cost of any structure or Property is the sum of its first cost and the present worth of
all costs for replacement, operation, and maintenance for a long time or forever, or

Capitalized cost = First cost + Cost of Perpetual Maintenance

Annual cost of any structure or property is the sum of the annual depreciation cost, interest of
the first cost and the annual operating and maintenance costs, or

Annual cost = Annual Depreciation cost + Interest of the First Cost

+ Annual Operating & Maintenance Costs

Examples
1. An item is purchased for P100,000. Annual cost is P18,000. Using interest rate of 8%, what is
the capitalized cost of perpetual service?
Solution
A
Capitalized cost = FC +
i
18000
Capitalized cost = 100000 +
0.08
Capitalized cost = 325,000 ans.

2. A motorcycle costs P50,000 and has an expected life of 10 years. The salvage value is
estimated to be P2,000 and annual operating cost is estimated at P1,000. What is the
appropriate rate of return on the investment if the annual revenue is P10,000?
Solution
To get the rate of return, i, equate annual cost and annual revenue:
Use sinking fund method
Annual cost = ¿ + FC(i) + O.C (Operating Cost)
10000 = (50000−200)(i)
¿¿
9,000 =
( 48000 ) (i)
¿¿
i = 0.1272 or 12.72% ans.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
7
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Summary:

Depreciation means the decrease in the value of physical properties or assets with the passage of
time and use. The types of depreciation method are Straight Line Method, Declining Balance Method,
Sum of the Years Digit Method, Sinking Fund Method, and Working Hours Method.
Depletion cost is the reduction of the value of certain natural resources such as mines, oil,
timber, quarries, etc. due to the gradual extraction of its contents. There are two methods of computing
depletion: (1) using Unit or Factor Method and (2) percentage or depletion allowance method.
Capitalized cost of any structure or Property is the sum of its first cost and the present worth of all
costs for replacement, operation, and maintenance for a long time or forever.
Annual cost of any structure or property is the sum of the annual depreciation cost, interest of the
first cost and the annual operating and maintenance costs.

Reference:

Park, C. S. (2012). Fundamentals of Engineering Economics. Chan S. Park. Pearson Education.

Sullivan, W. G., Wicks, E. M., & Luxhoj, J. T. (2003). Engineering economy (Vol. 13). Upper Saddle
River, NJ: Prentice Hall.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
8
 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

INSTRUCTIONS: Copy and answer the following problems. Incomplete solutions

will not be credited. Work independently. (USE THE ATTACHED ANSWER
SHEET)

I. Solve the following problems that involve depreciation and depletion.

1. The initial cost of a paint sand mill, including its installation, is P80000. The BIR
approved life of this machine is 10 years for depreciation. The estimated salvage value of
the mill is P5000 and the cost of dismantling is estimated to be P1500. Using straight-line
depreciation, what is the annual depreciation charge and what is the book value of the
machine at the end of seven years?
2. Shell Philippines, a multinational company, has a total gross income for a particular year
of P5000000. The taxable income after taking all deductions except for depletion is
P850000. What is the allowable depletion allowance for that particular year? Take
percentage of gross income for oil as 23%.
3. A unit of welding machine cost P46,000 with an estimated life of 8 years. Its salvage
value is P2,500. Find its depreciation rate by straight-line method.
4. The initial cost of a piece of construction equipment is P300000 having a useful life of 11
years. The estimated salvage value of the equipment at the end of the useful life is
P45000. Determine the book value of the construction equipment at the end of 4th year
and depreciation for 4th year using Sum-of-the-years-digits method?
II. Calculate the following problems apply annual and capitalized cost.

5. At 8%, find the capitalized cost of a bridge whose cost is P2.5M and life is 10 years, if
the bridge must be partially rebuilt at a cost of P1M at the end of each 10 years.
6. A corporation uses a type of motor truck which costs P50000 with life of 3 years and
final salvage value of P8000. How much could the corporation afford to pay for another
type of truck of the same purpose whose life is 5 years with a final salvage value of
P10000. Money is worth 5%.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF
REPRODUCTION, DISTRIBUTION, UPLOADING, OR POSTING ONLINE IN ANY FORM OR BY ANY MEANS WITHOUT
THE WRITTEN PERMISSION OF THE UNIVERSITY IS STRICTLY PROHIBITED.
9