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ENGINEERING ECONOMY Sixth


Edition
Blank and
Tarquin

CHAPTER 16

DEPRECIATION METHODS

Mc
Gra
Hill
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Chapter 16 Preliminary Statement

The material presented in this


chapter applies to the current
(2001) U.S. Federal Corporate
Income Tax Code relating to
depreciation.
As such, which changing
legislation, parts of this chapter
could be modified by legislation
enacted after publication of this
text.
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Chapter 16 Preliminary Statement


cont.

Students are encouraged to


research the current depreciation
rules as they may pertain to the
material in this chapter.
The IRS web site { www.irs.gov }
should be accessed for IRS
Publication 946 for the current
rules and regualtions.

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Chapter 16 Learning Objectives


1. Depreciation Terminology
2. Straight Line Depreciation
3. Double Declining Balance
Depreciation
4. Modified Accelerated Cost
Recovery System (MACRS)
5. Determining the MACRS Recovery
Period
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Section 16.1 Depreciation - Definition

Depreciation is the reduction in


value over time of an asset.
Brought on by:
 Wear and tear, use;
 Deterioration;
 Obsolescence.
Other definitions follow:

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16.1 Depreciation - Definition

Depreciation – Original Reason:


 Purely economic!
Economic View:
 Depreciation represents a “ratable”
using up of devaluation of a productive
asset.
 The asset must have a finite life span
that can be reasonably estimated.
 Deprecation represent a proper charge
against future income produced by the
asset in question.
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16.1 Depreciation and Depletion

Depreciation provides for the


retirement of a productive asset;
Depletion provides for the use of a
natural resource;
Amortization recognizes a prepaid
expense for tax purposes.

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16.1 Importance of Depreciation

Federal tax law defines the


concept of “taxable income” as:
 Gross Income – Real Cash Expenses –
interest – Depreciation amounts.
Tax Due =
 {Taxable Income}(Tax Rate).
Taxes and after-tax cash flows are
presented in Chapter 17.

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16.1 Tax Deductions

Federal Tax law permits the reduction of


Gross Income by a category of elements
termed “deductions”.
Most “deductions” are real cash flows:
 Wages and salaries;
 Cost of materials;
 Utilities;
 Interest Paid on debt;
 State and local taxes paid;
 Etc

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16.1 Tax Equation

The General Federal Tax Equation is:

Tax. Income = Gross Income – {Real


Expenses + Interest Paid + Depreciation +
Depletion}

All of the above amounts EXCEPT


depreciation amounts and depletion amounts
are real cash flow to the firm.

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16.1 Non-cash flow amounts

Depreciation and depletion


amounts represent “non-cash flow”
amounts within an accounting
period.
Federal and state tax laws
recognize various forms of
depreciation amounts and
depletions amounts to be “tax
deductible amounts” – but are not
real cash flows per se.
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16.1 After-Tax Cash Flows

All “for profit” firms seek to


minimize legally their respective
income tax liabilities.
Depreciation and depletions
amounts will lower the taxable
income amount and hence the tax
liability if claimed.
This chapter focuses on the
various forms of depreciation and
depletion calculations.
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16.1 Depreciation Amounts

Federal tax law states that:


 Any productive asset with a finite life
(greater than one year) must be
depreciated for tax purposes rather than
“expensed” in the year of purchase.
Depreciation amounts represent a
prorated amount per year that can be
treated as an “expense” (deduction)
but is not a real cash flow.

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16.1 Tax Savings from Depreciation

Depreciation amounts represent a


form of tax savings to the
profitable firm.
Assume a tax rate of say 30%.
For every $1 of eligible deductions
the resultant tax savings is:
 (0.30)($1.00) = $0.30.
 $1 of additional deductions saves the
firm $0.30.

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16.1 Simple Example

Consider a basic sewing machine


that is used to sew shoes;
Assume this sewing machine sews
300,000 pairs of shoes, pair by
pair.
The sewing machine is loosing
value over time due to the use of
the machine.
An Economic Concept is at play….

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16.1 Simple Example

If the sewing machine costs $2500 to


begin with then;
The initial cost of the sewing machine
should be prorated over the 300,000
pairs of shoes.
The initial cost of the sewing machine
is termed the BASIS of the asset.
One can allocate the original basis
over the number of pairs of shoes the
machine produces.

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16.1 Types of Depreciation

Book Depreciation
 Used by a firm for internal financial
and managerial management.
Tax Depreciation
 Used by a firm for state and federal
income tax reporting.
 Follows strict rules and regulations.

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16.1 Book Depreciation

Value of the asset on the firm’s


accounting records at any given
point in time.
Used for internal managerial
decision making.
Management is free to use any
method they so choose to compute
book depreciation amounts.

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16.1 Book Depreciation

Used internally by the firm;


Be any method:
 Straight Line,
 Declining Balance;
 Sum of the years digits;
 Other.
Defines the reduced investment in
an asset based upon usage pattern
and an assumed life.

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16.1 Tax Depreciation

Tax Depreciation:
 Must follow current state and federal
law pertaining to acceptable methods
for computing depreciation for income
tax purposes.
Federal Lever (2001)
 MACRS Methods
 General Depreciation System (GDS).
 Alternate Depreciation System (ADS).

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16.1 Book Value of an Asset

Book value:
 Accounting Term,
 Reflects the undepreciated (value) on
the firms books at a given point in
time.
 May or may not reflect the true market
value of the asset at a point in time.
 Market value of an asset is what a
willing buyer and willing seller agree to
consummate a sale or exchange.

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ENGINEERING ECONOMY Fifth Edition Mc


Blank and Gra
Tarquin Hill
w
CHAPTER 16

Section 16.1
DEPRECIATION TERMINOLOGY
Important Terms and their
meanings

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16.1 Terminology

The following slides state and


define depreciation terminology;
Terminology is very important to
the understanding of this chapter;
Please focus on the terms and
their respective meanings.

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16.1 BASIS of an Asset (B)


The Basis of an asset is:
 Purchase cost plus,
 Delivery Costs plus,
 Installation costs and,
 Any other costs associated with installing and
preparing the asset for use.
 To be eligible for depreciation the asset
MUST be placed in-service and ready for use.
 Symbol: B for “Basis” – A dollar amount.

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16.1 Book Value of an Asset (BVt)

The remaining, undepreciated capital


investment on the firm’s books after
the accumulated amounts of
depreciation have been subtracted
from the original cost basis.
BV’s are usually updated at the end of
the firm’s accounting year.

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16.1 Recovery period - n


Recovery Period (in years) is the
depreciable life n of the asset in
years.
Often there are different n values
for book and tax depreciation.
Both of these values may be
different from the asset's
estimated productive life.
Also know as the Depreciable life.
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16.1 Market Value (MVt)

Market value, a term also used in


replacement analysis, is the
estimate amount realizable if the
asset were sold on the open
market.
Because of the structure of
depreciation laws, the book value
and market value may substantially
different.

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16.1 Market Value (MVt)

For example, a commercial building


tends to increase in market value,
but the book value will decrease as
depreciation charges are taken.
A Computer workstation may have
a market value much lower than its
book value due to rapidly changing
technology.

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16.1 Salvage Value - S

Salvage value is the estimated


trade-in or market value at the end
of the asset's useful life.
The salvage value, S expressed as
an estimated dollar amount or as a
percentage of the first cost, may be
positive, zero, or negative due to
dismantling and carry-away costs.

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16.1 Salvage Value - S

Salvage values are estimated “up-


front” – at the time of the original
purchase.
As an estimated value, the actual
salvage value out at time t = n may or
may not reflect the original estimate.
Generally speaking, one cannot
depreciate an asset below it’s
estimated salvage value.

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16.1 Depreciation rate - dt

Depreciation rate or recovery rate


is the fraction of the first cost
removed by depreciation each year.
This rate, denoted by dt may be the
same each year, which is called the
straight-line rate, or different for
each year of the recovery period.

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16.1 Personal property

Personal property, one of the two


types of property for which
depreciation is allowed, is the income-
producing, tangible possessions of a
corporation used to conduct business.
Not to be confused with an
individual’s personal property like
clothes, furniture, etc.

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16.1 Personal property - continued

Included are
 most manufacturing and service
industry property-vehicles,
 manufacturing equipment, materials
handling devices, computers and
networking equipment,
 telephone equipment office furniture,
refining process equipment, and much
more.

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16.1 Real property

Real property includes:


 real estate and all improvements
 office buildings,
 manufacturing structures,
 test facilities,
 warehouses,
 apartments, and other structures.

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16.1 Real property

Real property includes real estate and


all improvements-office buildings
manufacturing structures, test
facilities, warehouses, apartments,
and other structures.
Land itself is considered real
property, but it is not depreciable
because it has an infinite life – land
can never be depreciated for tax
purposes.
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16.1 The Half-year convention

During a tax year, assets are purchased


and installed throughout the first year.
Under past laws, the first year of
depreciation had to be prorated by the
number of months remaining in the tax
year.
Under current federal tax law the first
year is handled using the half-year
convention.

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16.1 The Half-year convention

Half-year convention assumes that


assets are placed in service or
disposed of in midyear, regardless of
when these events actually occur
during the year.
This convention is utilized in this text
and in most U.S.-approved tax
depreciation methods.
There are also mid-quarter and mid-
month conventions.
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16.1 Property Eligible for Depreciation

Real or Personal;
 Productive Assets;
 Buildings and structures but not land.
Used in the pursuit of income
generation;
Have a finite, estimatable life

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16.1 Section “38” Property

Often the term “Section 38” or,


Section 1238” is used:
Section 1238 (from the IRS Code,
Section 1238) is defined as:
 Tangible personal property (but not
buildings or their structural
components) that is eligible for
depreciation under the Federal tax
code.

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16.1 Code Section 1250 Property

Under the IRS code, Section 1250


property is “real” property:
 Buildings and structures eligible for
depreciation.
Summary:
 Section 1238 – Personal Property,
 Section 1250 – Real Property.

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16.1 Depreciation Models

Basic (traditional) models are:


 Straight Line Method (SL),
 Sum-of-the years Digits (SYD),
 Declining Balance Method (DB).
 Today, the MACRS Method (a form of
declining balance-modified).

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16.1 Classical Methods

Classical Methods (supporting


Excel functions) are:
 Straight-line,
 SYD;
 DB.
See Appendix at the end of chapter
16.

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16.1 Section 179 Deduction

Section 179 Deduction:


 Special provision of the tax code:
 Benefits the small business:
 Provides an economic incentive for
small businesses to invest in assets
required to produce a profit:
 Permits the “expensing” of up to a
certain amount of investment in
depreciable assets in a given tax year.
(one-year write-off).

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16.1 Section 179 Allowance

The 179 allowance can reduce the


current year’s income tax liability.
Has a statutory maximum:
 For 2001 – Max. Amount = $24,000
 For 2003 – increases to $25,000.
If more than $200,000 is invested
in a given year the 179 amount is
reduced dollar for dollar.

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16.1 History

Before 1981 – US code recognized


the classical methods.
1981 and after:
 Classical methods were disallowed for
Federal Tax purposes and replaced
with a system termed “ACRS”.
 ACRS – Accelerated Capital Recovery
System.
 1986 ACRS was replaced with MACRS –
Modified Accelerated Capital Recovery
System.
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16.1 Today….

US Federal Corporate Income


Taxes must be computed using the
MACRS system!
States who have corporate income
tax laws generally permit all or part
of the classical methods to be used
for state corporate tax analysis.

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16.1 Comparison of Methods

It is beneficial to compare:
 Straight-line,
 SYD, and
 DB methods.
The best way is to plot the book
values of each method vs. the
recovery period (time).
See Figure 16.1 on page 510.

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16.1 Book value vs. Time: General


Case

In general, a book value plot will


look like:

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16.1 Book Value Plot for Classical


Methods

For SL, DB, and MACRS we have:

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16.1 Accelerate Depreciation

From Figure 16-1 on page 510:


 SL book values decline in a linear
fashion down to a specified salvage
value.
 The DB methods allows the book value
to accelerate faster since the DB plot
of book value is below the SL book
values.
 MACRS also permits accelerated book
values but not as good as the pure DB
method permits.

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16.1 Accelerating Depreciation

The SL methods writes off the


asset in equal amounts over the
recovery period.
The DB methods permits greater
depreciation amounts in the early
years and hence, reduces the book
value faster than the SL method.
Likewise for the MACRS method!

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16.1 Accelerating Depreciation

More depreciation in the early


years means more tax savings
sooner.
Assumes a profitable firm.
Tax savings early in the life of an
asset has a greater present value
that tax savings out in time.
Larger depreciation amounts early
on result is increased PW of future
tax savings to the firm.
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16.1 What Does it Mean?

If the firm is profitable then more


depreciation amounts in the early
years means:
 Lower tax liability;
 Pay less taxes – more $$ available for
reinvestment!
 The firm can retain more after-tax
funds if the depreciation is accelerated
in the early years of an assets’ life.
 Thus, more depreciation $$ early on
are better!
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16.1 Keeping Up

All engineers engaged in the


analysis of industrial projects need
to be reasonably informed
regarding the current Federal Tax
law regarding depreciation.
The law does change!
Must keep up with the changes!
IRS Web site: www.irs.gov
 Check it out for downloadable
publications
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CHAPTER 16

Section 16.2
STRAIGHT-LINE (SL)
DEPRECIATION

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16.2 Straight-Line: The Standard (SL)

SL depreciation is the standard from


which all other plans are compared.
Assumes the book value declines in a
uniform manner down to a specified
salvage value – S over n time periods.
Assume n years for an asset’s life:
 The depreciation rate –dt is then:

Dt = 1/n

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16.2 SL Example

Notation (to be followed herein)


 t = the year (t = 1,2, …, n)
 Dt = Annual depreciation charge,
 B = the first cost or unadjusted
Basis,
 S = Estimated Salvage Value at t =
n,
 n = The Recovery Period,
 d = The Depreciation Rate = 1/n
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16.2 Straight Line Method

Compute the Basis minus the


estimated salvage value and divide
by n

Dt = ( B − S )d [16.1]

B−S
Dt = [16.2]

n
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16.2 SL Excel Function

In Excel the built-in function is:

SLN(B,S,n)

Displays the annual depreciation Dt as a


single cell operation.

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16.2 SL Example

B = $50,000;
“n” = 5 years;
S = $10,000 at t = 5;
Dt for each year is:
 ($50,000 - $10,000)/5 = $8,000/year

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16.2 SL Example: Tabulation


t Dt BVt

1 $8,000 $42,000

2 8,000 34,000

3 8,000 26,000

4 8,000 18,000

5 8,000 10,000

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16.2 Plot of the Straight-line Book


Value

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16.2 SL Observations

The SL method starts at B and


directly targets “S” n time periods
from the present.
The Depreciation amounts are all
equal ($8,000 in this case).
The book values decline at the
same rate down to $10,000.

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CHAPTER 16

Section 16.3
DECLINING BALANCE AND
DOUBLE DECLINING BALANCE
DEPRECIATION

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16.3 Declining Balance Method (DB)

DB is an accelerated depreciation
method;
Provides greater depreciation
amounts in the early time periods
over straight-line.
The method is more complex that
the SL method.
Requires assuming a DB rate –
normally taken to equal 2 x SL rate.

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16.3 DB Rate

Given the DB rate,


 Dt for year t is found by multiplying the
beginning of time period book value by
the rate.
The maximum DB rate set by law
is:
 dMAX = 2(1/n) or, twice what the straight rate
would be.

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16.3 DB Equations Depr. For year “t”

Dt = (d ) BVt −1 [16.5]

t −1
dt = (d ) B (1 − d ) [16.6]

Depr. Rate

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16.3 DB if BVt-1 Not Known


If BV at the end of the preceding
year is not known apply:

t −1
Dt = (d ) B (1 − d ) [16.7]

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16.3 DB: Book Value Determination

BVt can be determined in two ways:


 1. Using the rate d and the basis, B or,
 2. Subtracting the current year’s
depreciation from the previous year’s
book value.
BVt from d and B:
 Apply:
BVt = B (1 − d ) t
[16.8]

BVt = BVt −1 − D [16.9]

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16.3 DB: Implied Salvage Value

Note, from equations 16.4 – 16.9 there


is no mention of the salvage value –S!
DB does not directly use the estimated
salvage value.
DB has its own implied salvage value.
The pure DB method will never
depreciate an asset down to a “0”
salvage value unless you solve for a
“d” rate ( Eq. 16.11).

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16.3 DB: Implied Salvage Value

The implied salvage value built


into the DB method is:

S = BVn = B(1 − d ) n
[16.9]

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16.3 Implied SV for DB Depreciation

Permissible range for d is:


0 < d < (2/n)
To force a prescribed salvage
value – S apply:
 Implied d = 1 – (S/B)1/n [16.11]

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16.3 DB rate - d

By law, the maximum rate for DB is


specified to =:
 Twice the SL rate for a given n.
 This is called “The Double Declining
Balance Rate”.
 If d = 1.5(SL rate) it is termed the
150% DB rate.
 d can never exceed 2(1/n) but can be
less!

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16.3 Excel DB Functions

Excel supports the DB approach as


a single cell function:
Use:
 DDB(B,S,n,t,d) as a cell function.

 “d” argument can be omitted: If so, a


“d” of 2 is assumed by Excel.
Excel also supports a “DB”
function.
 Suggest one avoid using this one as
special care must be taken! DB(B,S,n,t)
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16.3 Example 16.3

B = $80,000;
n = 10 years;
S = $10,000;
Apply the DB and DDB methods to
compute the depreciation amounts
and associated BV’s.

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16.3 Example 16.3 DB approach

The DB methods first computes the


implied salvage value from:
 d = 1 – (10,000/80,000)1/10 = 0.1877
 d = 18.77% will target the $10,000 SV
at t = 10.
See Table 16-1 on page 515.

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16.3 Spreadsheet Model for Ex. 16.3

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CHAPTER 16

Section 16.4
MODIFIED ACCELERATED COST
RECOVERY SYSTEM
MACRS

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16.4 MACRS Method

MACRS was derived from the 1981


ACRS system and went into effect
in 1986.
Defines statutory recovery
(depreciation) percentages.
Percentages were derived from the
DB method with a switch to SL at
the optimal time and,
Incorporates the half-year
convention.
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16.4 MACRS Salvage Value

The MACRS approach assumes a


salvage value of “0” even though
that might not be the case!
By current law – MACRS assumes
all assets depreciated by this
method will have a “0” salvage
value at the end of the recovery
life.

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16.4 MACRS Actual Depreciation

Depreciation for year “t” is:


 Dt = dt(B)
[16.12]
 dt = a depreciation rate (per cent)
applicable for the t-th year.
 The dt’s are published percentage
rates and cannot be changed.

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16.4 MACRS Book Values

MACRS book values are


determined from:
 BV = BV – D [16.13]
t t-1 t
 Or,
 BVt = Basis – sum of accumulated
depreciation.
j =t
BVt = B − ∑ D j [16.14]
j =1
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16.4 Observations

Under MACRS:
 The entire Basis (B) is fully depreciated
(recovered) over a specified number of
years (recovery periods).
 A “0” salvage value is a functional part
of the MACRS system – by law.
 In reality, there may be a positive, “0”,
or negative salvage value at some
point in time.
 Adjustments will have to be made at
that time. (Disposal analysis)

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16.4 MACRS Recovery Periods

For Personal Property the following


MACRS recovery periods apply:
 3- years,
 5-years,
 7-years,
 10-years,
 15-years and,
 20-years.
Six Property Classes for Personal
Property – mid-year convention applies.

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16.4 MACRS Personal Property Recovery


Rates
Year-t 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 0.3333 0.2000 0.1429 0.1000 0.0500 0.0375
2 0.4445 0.3200 0.2449 0.1800 0.0950 0.0722
3 0.1481 0.1920 0.1749 0.1440 0.0855 0.0668
4 0.0741 0.1152 0.1249 0.1152 0.0770 0.0618
5 0.1152 0.0893 0.0922 0.0693 0.0571
6 0.0576 0.0892 0.0737 0.0623 0.0529
7 0.0893 0.0655 0.0590 0.0489
8 0.0446 0.0655 0.0590 0.0452
9 0.0656 0.0591 0.0446
10 0.0655 0.0590 0.0446
11 0.0328 0.0591 0.0446
12 0.0590 0.0446
13 0.0591 0.0446
14 0.0590 0.0446
15 0.0591 0.0446
16 0.0295 0.0446
17 0.0446
18 0.0446
19 0.0446
20 0.0446
21 0.0223
1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
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16.4 Real Property Classes

Real Property – buildings,


structures, residential rental and
non-residential office-factory types:
 27.5-years for residential rental
property;
 39 years for all other properties.
 Published percentages prorated by
months of the year the property is
placed in service.
 Assumes a mid-month convention.

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16.4 39-Year Depreciation Rates

Straight Line Method for n = 39.


d = 1/39 = 0.02564 or 2.564% per
year;
Except in year 1 and in year 40
where technical adjustments are
made in the percentages.

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16.4 Recovery Lives

Examine Table 16-2 on page 518.


You will see the 6 Recovery
Classes and their associated
percentages.
Note, for each life category there
are n+1 percentage values where n
is the class life.
Example:
 Three-year Recovery period there are 4
recovery percentages!
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16.4 Nominal Recovery Periods

3- year property is really recovered


over 4 years;
5-year property is really recovered
over 6 years;
And so forth for each of the other
classes.
Why is this the case?

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16.4 n+1 Rule

The actual recovery of a given


class life assumes a half-year
convention.
That is, it is assumed by law that
an asset is placed in-service at the
middle of the first year.
It does not matter when it is
actually placed in-service;
So, only a ½ year of recovery is
permitted in the first year.
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16.4 n+1 Explained

By law, ½ year of recovery is


permitted in the first year and,
The remaining recovery is spread
out over n additional years.
See Appendix 16A.3 for more
details.

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16.4 Derivation of the 3-year MACRS


rates

For recovery periods of 3,5,7, and 10


years, the 200% DB with a switch to
straight line is imposed.
For n = 3, the Straight-line rate is 1/3.
Twice the straight-line rate is 2(1/3) or
2/3. (0.6667)
Assume a basis of $1.00 for simplicity;
Let the original basis at time t = 0 =
1.000.

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16.4 3-Year analysis: First Year

B = 1.000
DDB rate = 0.6667;
But only ½ year in year 1 is
permitted by law so,
d1 = 0.6667/2 = 0.3333;
D1 = (0.3333)(1) = 33.33%
BV1 = 1 – 0.3333 = 0.6667
remaining at the end of year 1.
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16.4 Year 2.
BV at the end of year 1: 0.6667B;
To be recovered over 3 years.
Rate for year 2 is (from DDB)
 0.6667(0.6667) = 0.4445 or 44.45%
 So, d2 = 44.45% and,
 D2 = 44.45% of B.
 BV2 = BV1 – D2 = 0.6667B – 0.4445B;
 BV2 = 0.2222B ( 2 years remaining to
recover).
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16.4 Year 3: Should one switch to SL?


BV2 = 0.2222B;
SL amount over 2 years would be:
 0.2222/2 = 0.1111 for each year;
What is the MACRS deduction for year 3 if
DDB is applied?
 d3 = 0.6667(0.2222B) = 0.1481 or 14.81%
 Which is greater for year 3?
 11.11% by switching or,
 14.81% by staying with DDB?
 Ans: Go with the 14.81% …greater than
11.11%
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16.4 Year 4

Take the 14.81% of the Basis for year 3;


Book value at the end of year 3 will be BV2
– D3 = 0.2222B - .1481B = 0.0741B.
If BV3 = 0.0741B and there is only one
more year remaining then to achieve a “0”
salvage value at the end of year 4 we take
d4 = 0.0741 – we are done!

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16.4 Completed MACRS 3-year Rates


t dt BVt

1 0.3333 0.6667B

2 0.4445 0.2222B

3 0.1481 0.0741B

4 0.0741 0

1.0000
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CHAPTER 16

Section 16.5
DETERMINING THE MACRS
RECOVERY PERIOD

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16.5 MACRS Recovery Periods

For book depreciation one should


use a life the best reflects the
anticipated or expected useful life.
For tax depreciation one generally
wants as short as possible recovery
period to generate more immediate
tax savings.
For book depreciation use whatever
life best defines the usage rate of
the asset.
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16.5 MACRS Recovery Lives

For Federal tax purposes, the proper


recovery life is found from IRS
publications (Pub 946).
Table 16-4 illustrated general asset
descriptions and their respective
MACRS recovery periods permitted
by law.
These breakdowns are termed
Property Classes.

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16.5 Property Classes - Examples

3- Year Property:
 Special manufacturing and handling
devices, tractors and racehorses.
5- Year Property:
 Computers and peripherals,
 Duplicating equipment.
 Automobiles, trucks, buses,
 Cargo containers,
 Some manufacturing equipment.

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16.5 Property Class Examples

7 –Year Property Class:


 Office furniture,
 Some manufacturing equipment,
 Railroad cars, engines and tracks,
 Agricultural machinery,
 Petroleum equipment and natural gas
equipment,
 All property not in another class!
The 7-year class is the ‘default’
class!
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16.5 MACRS Recovery Lives

10-Year Class:
 Water transportation equipment,
 Petroleum refining,
 Agricultural processing equipment,
 Durable goods manufacturing
equipment,
 Ship building.

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16.5 Property Classes - continued

15-Year Class:
 Land improvements,
 Landscaping,
 Pipelines,
 Nuclear power production equipment,
 Telephone distribution and switching
equipment.

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16.5 Property Classes - continued

20-Year Class:
 Municipal sewers, (developers)
 Farm buildings,
 Telephone switching equipment,
 Power production equipment,
 Water utilities equipment.

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16.5 Property Classes - continued

27.5-Year Property: (Real Property)


 Residential rental property (homes and
mobile homes).
39-Year Property (Real Property)
 Nonresidential real property attached to
the land, but NOT the land itself.

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16.5 Recovery Classifications

Engineers should have access to the


current IRS publications regarding
property classes.
If, in doubt, an inquiry can be made
(in writing, to the regional office of
the IRS for a ruling as to what class
questionable property will be
accepted.

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16.5 The Alternate Depreciation


System

The IRS offers what is termed the


Alternate Depreciation System – ADS.
It is a modified form of the MACRS
system.
Applies a straight-line approach with
the half-year convention.
Generally used by small or growing
firms that do not have sufficient taxable
income now and in the immediate future.

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16.5 ADS: Overview: 5-Year Example

ADS applies a form of the straight-


line method with the half-year
convention.
Assume 5-Year Property Class;
 “n” = 5;
 1/n = 0.20 per year except in the first
year and in the last year (n=6)
 Year 1: d1 = ½(0.20) = 0.10 or 10% of B
 Years 2-5 = 0.20 or 20% of B;
 Remaining amount – 10% flows over to
the last year, t = 6.
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16.5 ADS: 5-Year Rates Tabulated


“t” dt BVt
1 0.10 0.90B
2 0.20 0.70B
3 0.20 0.50B
4 0.20 0.30B
5 0.20 0.10B
6 0.10 0

1.00
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16.5 ADS: Reason For.


The ADS is available to smaller firms or firms
that are just starting up.
Some firms may not be generating sufficient
profits to take advantage of the more
accelerated depreciation rates that the
MACRS-GDS provides.
Thus, if GDS is elected, the firm may be
loosing deductions in the early years.
ADS provides some relief for firms in this
situation.

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16.5 ADS: Election

For both the ADS and the GDS:


 For a given tax year the firm elects
either the:
 ADS system for all assets placed in
service for the current tax year or,
 The GDS (accelerated method) for all
assets placed in service for the
current tax year.
The firm cannot mix ADS with GDS
within the tax year! (one or the
other.)
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16.5 ADS - GDS:

In engineering economy analysis of


industrial projects:
 Most analysis will be accomplished
using the GDS – accelerated
depreciation rates.

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Section 16.6 DEPLETION METHODS

Depreciation or cost recovery is


applied to assets that can be
replaced.
Depletion applies to resources that
are not easily replaced like:
 Timber,
 Mineral deposits,
 Oil and gas,
 Etc.

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16.6 DEPLETION: Two Types

Cost Depletion
 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
firm’s current taxable income.

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16.6 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 …next slide…

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16.6 DEPLETION: Cost Depletion


Factor

Let t denote the year;


pt denotes the depletion factor for
year t.
Then, pt is defined as:

first cost
pt = [16.15]
resource capacity

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16.6 DEPLETION: Cost Method Example

Example 16.5 page 523


Company buys timber rights to
land for $700,000 at time t = 0.
Estimated 350 million board feet
that can be harvested.
 This is important: A realistic estimate
of the resource must be accomplished
up front!
 Re-estimates can be made in the future
and adjustments made.

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16.6 DEPLETION: Important Issue

Major Point for 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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16.6 DEPLETION: Example 16.5

Determine the cost depletion amount


for the first two years of harvesting
if:
 Year 1: Harvest 15 million bdft and,
 Year 2: Harvest 22 million bdft.
Compute pt as:
 pt = ($700,000)/350 m-bdft = $2,000/m-
bdft.
 Deplt=1 = 15M-bdft($2,000) = $30,000.
 Deplt=2 = 22M-bdft($2,000) = $44,000.
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16.6 DEPLETION: Example 16.5

Year 1 depletion allowance = $30,000


Year 2 depletion allowance = $44,000
For year 1 the $30,000 can be treated
as a deduction from gross income so
long as the depletion amount does not
exceed the first cost of the resource.
Likewise, $44,000 can be deducted
from year 2’s Gross Income.

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16.6 DEPLETION Example

For the first 2 years the recovery


is:
 Year 1:
 $700,000 - $30,000 = $670,000 left to
recover:
 Year 2:
 $670,000 - $44,000 = $626,000 left
to recover.
This process continues so long as
the original estimate applies.

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16.6 DEPLETION - Example

Original Estimate – 350 m-bdft


After years 1 and 2, 37 m-bdft have
been extracted leaving and estimated:
 350 – 37 = 313 m-bdft of the resource left.
This process continues on until the
original $700,000 investment is
written off or….
A revised estimate of the resource is
made.

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16.6 DEPLETION: Revision of the


Resource

Assume at the end of year 2 the


resource capacity is re-estimated.
Assume the re-estimate reveals
that there is 450 m-bdft remaining
to start year 3.
Revision of the factor is now
necessary.
Remember, $626,000 remains from
the initial investment of $700,000.

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16.6 DEPLETION – Revision for Year 3


on

Cost basis for year 3 is $626,000


New pt is calculated as:
 pt = $626,000/413 = $1,516/M-bdft.
 For years 3 on the $1,516/m-bdft is applied to
calculate the depletion allowance.
 Use this factor until the $700,000 investment is
fully written off or another re-estimation is
conducted.
 The process stops when the $700,000 is “0”.

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16.6 DEPLETION: Percentage Depletion

Percentage depletion uses IRS


mandated percentages for classes
of resources.
The depletion allowance for this
method cannot exceed 50% of the
firm’s taxable income before the
depletion allowance is claimed.
Percent Depletion =
 Percentage(gross income from activity)

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16.6 DEPLETION: Percent Method


Deposit Percentage
Sulfur, uranium, lead,
nickel ,zinc,
22%
gold, silver ,copper,
iron ore and
geothermal deposits 15%
Oil and gas wells 15%
Coal, lignite, sodium 10%
chloride
Gravel, sand, peat, 5%
stone
Most other minerals 14%
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16.6 DEPLETION: Percent Method

Warning:
 These percents change over time due
to changes in the tax law.
 If you are involved in extraction
industry analysis you must keep up
with the current regulations and
percents for this method!

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16.6 DEPLETION

See Example 16.6 on page 524


Gold mine purchased for $10
million.
Estimated gross income for years 1-
5 of $5.0 million and $3.0 million
after year 5.
Depletion charges cannot exceed
50% of taxable income in any given
year (by current tax law).
For gold the rate is 15%/year.
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16.6 DEPLETION: Example 16.6


Years 1- 5:
 (0.15)(5.0 million) = $750,000/year
Years 5 on…
 (0.15)(3.0 million) = $450,000/year
First 5 years:
 Write-off = (5)($750,000) = $3.75 million
 There is $10 million - $3.75 m = $6.25 m left.
Years 6 on…
 5 + 6.25 m/$450,000 = 5 + 13.9 = 19 years
 The $10 m is fully recovered after 19 years.

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16.6 Depletion Law Requirement

The depletion allowance can be


determined using either the cost or
the percentage method.
The current law requires:
 Cost depletion be used IF the percentage
depletion is smaller in any year.
 This means that one should apply both
methods in the beginning.

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16.6 Depletion Law Requirement

Calculate both amounts:


 Cost Depletion ($-Depl)
 And percentage Depletion (%-Depl).
 Then apply the following rule each year:

%Depl if %Depl ≥ $Depl 


Annual Depletion =  
$Depl if %Depl p $Depl 

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Chapter 16 Summary

Depreciation may be determined for


internal company records (book
depreciation) or for income tax
purposes (tax depreciation).
In the U.S., the MACRS method is the
only one allowed for tax depreciation.
Depreciation does not result in actual
cash flows directly – rather, tax
savings are the result of depreciation.

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Chapter 16 Summary cont.

It is a book method by which the


capital investment in tangible
property is recovered.
The annual depreciation amount is
tax deductible, which can result in
actual cash flow changes.

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Chapter 16 Summary cont.:


Straight-Line Depreciation

It writes off capital investment


linearly over n years. The estimated
salvage value is always considered.
This is the classical, nonaccelerated
depreciation model.
Simple to apply and is a popular
method for computing book
depreciation.

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Chapter 16 Summary cont.:


Declining Balance

The model accelerates depreciation


compared to straight line.
The book value is reduced each
year by a fixed percentage.
The most used rate is twice the SL
rate, which is called double
declining balance (DDB).

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Chapter 16 Summary cont.:


Declining Balance
It has an implied salvage that may be
lower than the estimated salvage.
It is not an approved tax depreciation
method in the U.S.
It is frequently use for book
depreciation purposes.
May not target a specified salvage
value.
MACRS applies a modification of this
method to determine MACRS recovery
percents.
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Chapter 16 Summary cont.:


MACRS

It is the only approved tax


depreciation system in the United
States. It automatically switches
from DDB or DB to SL depreciation.
It always depreciates to zero; that
is, it assumes S = 0. Recovery
periods are specified by property
classes. Depreciation rates are
tabulated.

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Chapter 16 Summary cont.:


MACRS

The actual recovery period is 1 year


longer due to the imposed half-year
convention.
MACRS alternate straight line
depreciation is an option, and is
generally used by firms that are
growing and would be wasting
MACRS accelerated depreciation
amounts.

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Chapter 16 Summary cont.: Depletion


Depletion methods are used to recover
investment in the extraction or harvesting
of natural resources.
Two Methods:
 Cost Depletion,
 Percentage Depletion.
Specific rules apply to both methods.
 Normally, one would calculate depletion
allowances by both methods then apply the IRS
mandated permission rules.

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ENGINEERING ECONOMY Sixth


Edition
Blank and
Tarquin

End of Slide Set

M c
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Hill
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