Lecture 10 - Intro Depreciation

Lecture 10 - Intro Depreciation - CE 395 Engineering...

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Unformatted text preview: CE 395 Engineering Economics Spring 2005 W. Hitchcock 1. Overview of Equipment Costs 2. Introduction - Depreciation Review Thoughts Comparing Alternatives With Unequal Useful Lives When using NPW approach, endeavor to establish a common economic analysis period for all alternatives. In cases where useful lives are different, but the need is recurring (i.e. equipment will be replaced) AW analysis is sometimes acceptable using the different useful lives of the alternatives in the analysis. Considerations are: Will a piece of equipment be replaced with identical piece? Is there a common multiple of useful lives? Is the need considered indefinite or perpetual? Recurring Example AW Analysis Option Cost Salvage Useful Life A $12,000 0 4 yrs B $15,000 0 6 yrs If MARR is 7% and the equipment need is over 20 years, which do you choose? AW Example Solution EUACA= 12,000(A/P, 7%,4) = $3,543 EUACB= 15,000(A/P, 7%,6) = $3,147 Contractor Equipment Costs The major components of the Direct Field costs included Labor, Equipment, Materials, Other Direct Costs, and Subcontractors. Indirect Field costs also include some equipment costs as does Home Office Indirect Overhead. Successful contractors and other business operators understand the most economic approach to employing the equipment they need to get the job done. Major areas of the equipment plan What kind and how much? Own or lease? Cost recovery? The Basics Owned Equipment Costs Virtually all business endeavors require equipment to deliver the product or service. Two broad classes of equipment Production Support To be successful, businesses must include a suitable equipment charge component in the pricing of their product/services. The costs associated with owned equipment are typically classified in two categories: Fixed (Ownership costs) Variable (use dependent costs) Equipment Costs Fixed Costs (Ownership Costs) Fixed costs are costs incurred by the owner which are independent from the amount of use of the equipment. The primary components are: Finance costs Insurance Taxes (property) Depreciation or Amortization Loss of value (useful life) of equipment over it's lifetime recognized as a reduction in asset value each year over a specified economic life. We will discuss is detail shortly Equipment Costs Variable Costs Variable costs are costs incurred by the owner as a result of operating the equipment and maintaining the equipment over it's economic life. The primary components are: Fuel, lubricants, grease, etc. Consumable parts Scheduled maintenance Repairs Overhauls Operator Labor Costs (not always included with equipment) Note: While all of the costs above do not occur with each hour of use (such as maintenance) they are typically recovered on a unit of work basis. Equipment Cost Recovery Many contractors treat equipment as profit centers. In order to be a profit center, a piece of equipment would necessarily be billed to customers at a rate sufficient to recover not only its fixed and variable costs but would also include profit and allocation of some equipment support overhead. Depreciation What is Depreciation? 1. Decline in market value of an asset, or 2. Decline in value or utility of an asset to its owner, or 3. Systematic allocation of the cost of an asset (less its salvage value) over its useful life. Note: We will use the 3rd definition because it applies in the context of depreciation and income tax calculation. Property Categories Tangible (seen or touched) Personal Property (equipment, machinery, furniture, etc.) Real Property (land or anything connected to, growing on, or attached) Intangible (not seen such as copyright, patent, franchise, etc) We will focus only on tangible property Depreciation Qualified Assets Plant assets are assets held for more than one year and are not inventory or investment property. Land, buildings, equipment, furniture, machinery are typical examples. All plant assets except land depreciate over time: Physical depreciation Functional depreciation The depreciation of plant assets are an expense to the company. If an asset lasts several years, the capital expense of the asset is absorbed over the useful life. Businesses in the United States are taxed annually on the net profit income over the year (revenues less costs of doing business). Plant asset depreciation is an expense and thus reduces the amount of taxes a company pays at the end of the year Depreciation of Property Impact on Financial Statements Corporate income may be taxed at the Federal, State, and local levels. Income taxes can be a significant expense for a company. Annual equipment depreciation expenses reduce the net income for the year. Annual depreciation expenses increase cash flow for the year. Depreciation Tax Savings Help Fund Future Property Purchases This tax benefit helps a company pay for equipment. Example: Suppose a piece of equipment costs $100,000 and a company's average corporate income tax from all sources is 40% typically. Assume the salvage value is 0. Over the life of the equipment, the company claims $100,000 in depreciation expenses on tax returns. The net tax savings for the company over the life of the equipment is $ 40,000. The amount in tax savings will not be sufficient to replace the equipment, but certainly provides some relief for future capital expense. Depreciation Application Based on Tax Laws Keep in mind that depreciation for tax purposes and the actual physical or functional depreciation of plant assets are two different things. Companies want to use depreciation to their maximum advantage: Maximize depreciation claims when profits are high and tax rates high. Minimize depreciation when profits are low and tax rates are low The IRS Tax Code tightly controls how plant assets are depreciated. Depreciation Based on Tax Laws - Continued Plant assets placed into service prior to 1981 depreciation methods: Straight line depreciation method Sum-of-the-years-digits method Declining balance method Units of production method Plant assets placed into service after 1980 and before 1987: Straight line depreciation method Accelerated Cost Recovery System (ACRS) Plant assets placed into service after 1987: Straight line depreciation method Modified Accelerated Cost Recovery System (MACRS) Key Definitions Basis The initial cost of an asset to owner Adjusted Basis Asset initial cost plus improvements Salvage Value (SV) Estimated value of property at the end of its economic useful life Market Value What a willing buyer would pay for the asset Useful Life Economic useful life of property Recovery Period (N) Number of years over which the property is depreciated (not necessarily Useful Life) Book Value (BV) Adjusted Basis less allowable depreciation or depletion Why Study Multiple Depreciation Methods? Federal tax system uses MACRS State and local tax systems may still use classical methods International tax systems may employ the historical methods. Scope of study for us: Straight Line Depreciation (SL) Declining Balance Depreciation (DB) Sum-of-the-Years- Digits (SYD) DB with Conversion to SL Units of Production The Modified Accelerated Cost Recovery System (MACRS) Depletion Straight Line Depreciation Straight line depreciation assumes that the equipment loses value uniformly over it's useful life. Annual SL Depreciation = Cost - Salvage Value Useful Life SL Depreciation Example Example: Cost = $ 20,000, Salvage = 0, Useful Life = 5 yrs Year 0 1 2 3 4 5 Depreciation 0 $ 4,000 $ 4,000 $ 4,000 $ 4,000 $ 4,000 Book Value (end of year) $ 20,000 $ 16,000 $ 12,000 $ 8,000 $ 4,000 0 Declining Balance Depreciation Allows a company to accelerate the rate an asset depreciates. More depreciation expense declared in the early years compared to the later years of the life of an asset. Accelerated depreciation translates into greater tax savings in the early years of a piece of equipment's life. In declining balance depreciation, a given depreciation rate is applied each year to the book value of the asset (for that year) Declining Balance Depreciation Continued The depreciation rate is expressed as a multiple of the straight line rate. We will focus on the two rates used in the Tax Code: 200% of the straight line rate (called Double Declining Balance, DDB) 150% of the straight line rate Typically in Declining Balance Depreciation calculations, the salvage value (if any) is neglected If the salvage value is neglected for purposes of determining the annual depreciation the equipment book value cannot be reduced below the salvage value. This means that if the salvage value is not zero, care must be taken to insure that the book value does not reach a value less than the estimated salvage value. Declining Balance Depreciation Continued DB terminology: B = Cost Basis R = Recovery Rate dk = Depreciation in year "k" dk* = Cumulative depreciation at the end of year "k" BVk = Book value at the end of year "k" Useful formulas: R = DB Factor/N (depreciable life) dk = B(1-R)k-1(R) dk* = B[1-(1-R)k] BVk = B - dk* = B (1-R)k Double Decline Balance Example New equipment cost : $40,000. Useful Life: 5 yrs. 0 Salvage Value DDB Rate = R = [%200]/5 yrs =40%/yr or .40 Annual Depreciation = DDB Rate X Book Value Year 0 1 2 3 4 5 Depreciation 0 $ 16,000 $9,600 $ 5,760 $ 3,456 $ 2,058 Book Value (end of yr) $40,000 $ 24,000 $ 14,400 $ 8,600 $ 5,144 $ 3,086 Note: The book value is not zero at end of life Sum-of-the-Years-Digits (SOYD) Sum-of-Years-Digits = 1 + 2 + 3 + .... (N-1) + N = [N(N+1)]\2 # Remaining Yrs at Beginning of Year Sum-of-Years-Digits for Total Useful Life Depreciation any Year = { B SV) SOYD Example New equipment cost : $40,000. Useful Life: 5 yrs Salvage Value = 0 SOYD = 1 +2 + 3 + 4 + 5 = 15 = [5(1+5)]/2 Year 0 1 2 3 4 5 Depreciation 0 $ 13,333 $ 10,667 $ 8,000 $ 5,333 $ 2,667 Book Value (end of yr) $40,000 $ 26,667 $ 16,000 $ 8,000 $ 2,667 $0 Declining Balance With Conversion to SL Recall the book value did not reach zero in the DDB example. The same would have occurred with 150% Declining Balance The tax code provides a remedy. Declining Balance Method with conversion to straight line depreciation. Use the declining balance method until a conversion to the straight line method results in a higher depreciation amount. The straight line calculation uses the current book value divided by the remaining life Note: If an estimated salvage value is used, the book value cannot be reduced below the estimated salvage value Declining Balance with SL Conversion Example Year 1 2 3 4 5 DDB Depreciation $ 16,000 $9,600 $ 5,760 $ 3,456 $ 2,058 Book Value (end of yr) $ 24,000 $ 14,400 $ 8,600 $ 5,144 $ 3,086 DDB with conversion to Straight Line Year 1 2 3 4 5 Depreciation $ 16,000 $9,600 $ 5,760 SL $ 4,300 SL $ 4,300 Book Value (end of yr) $ 24,000 $ 14,400 $ 8,600 $ 4,300 $ 0 Unit of Production Depreciation Method not based on elapsed time. Intended for assets where depreciation is a function of use (hours, repetitions, etc.) { B SV) Depreciation Per Unit (DP/Unit)= Estimated Total Units of Production in Useful Life Depreciation for Year = (# Units Used)(DP/Unit) ...
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This note was uploaded on 09/26/2008 for the course CE 395 taught by Professor Hitchcock during the Summer '05 term at University of Alabama at Birmingham.

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