Lecture 11 - Depreciation and Taxes

Lecture 11 - Depreciation and Taxes - CE 395 Engineering...

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Unformatted text preview: CE 395 Engineering Economics Spring 2005 W. Hitchcock 1. MACRS Depreciation 2. Intro Depreciation and Taxes 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 Equipment Depreciation Current Tax Law - MACRS The tax code is complex but business decision makers must have an appreciation for it. You should always seek tax expert advice to insure depreciation is calculated properly Our purpose is to learn the basic MACRS concepts and employ them in examples MACRS was a radical departure from traditional depreciation methods Plant assets are divided into service life categories. Property Classes (Examples) 3-year property : Tractor units, racehorses over two years old, and horses over 12 years old when placed in service 5-year property : Automobiles, taxis, buses, trucks, computers and peripheral equipment, office machinery (faxes, copiers, calculators etc.), and any property used in research and experimentation. Also includes breeding and dairy cattle. 7-year property : Office furniture and fixtures, and any property that has not been designated as belonging to another class. 10-year property : Vessels, barges, tugs, similar water transportation equipment, single-purpose agricultural or horticultural structures, and trees or vines bearing fruit or nuts. Property Classes (Examples) - continued 15-year property : Depreciable improvements to land such as shrubbery, fences, roads, and bridges. 20-year property : Farm buildings that are not agricultural or horticultural structures. 27.5-year property : Residential rental property. 39-year property : Nonresidential real estate, including home offices. (Note: the value of land may not be depreciated.) Equipment Depreciation Current Tax Law (continued) User has the choice of GDS (General Depreciation System sometimes called MACRS) or ADS (Alternate Depreciation System - straight line). Figure 6-1 in the text (page 268) provides a flow chart for using GDS or ADS. If the GDS (MACRS) method is used, the actual service life and salvage value are not utilized in the calculation but are replaced with rigid mechanical calculations taken from specified depreciation tables depending on the category of the asset. Equipment Depreciation Partial Year Convention Generally equipment is not placed into service or taken out of service on January 1st. The tax code specifies that the first and last years of usage are partial depreciation years. This convention results in equipment being depreciated across a period 1 year longer than the stated depreciation recovery period. (example: equipment with a specified 5-year depreciation recovery period is depreciated over a 6-year period) Equipment Depreciation Current Tax Law (continued) Typically if Straight Line Depreciation (ADS) or MACRS(GDS) tables are used, first and last years' depreciation are based on -year use. (we will see example later). Mechanically we calculate the depreciation factor for the 1st and last year as usual (SL or DB) and divide the result by two. It should be noted that the 1st and last year convention is built into the published MACRS depreciation tables. MACRS Depreciation (GDS) Essentially MACRS is declining balance depreciation (either 200% or 150%) with conversion to straight line with the first and last partial year convention. Table 6-4 of the text (page 267) provides general guidance on required methodology and depreciation recovery period based on actual equipment class lives and types. Table 6-2 is an example list of equipment categorized by asset class. Table 6-3 provides the depreciation factors to be used for difference recovery periods. Depreciation Mechanics Information Needed Asset cost basis Asset class life When placed in service Depreciation method desired MACRS Depreciation Example Given: Asset cost is $30,000 and has a class life of 6 years. Determine the depreciation deductions using MACRS table: From Table 6-4 the recovery period is specified as 5-year Year 0 1. 2. 3. 4. 5. 6. MACRS% 20 % 32 % 19.2 % 11. 52 % 11.52 % 5.76 % Depreciation $6,000 9,600 5,760 3,456 3,456 1,728 $30,000 Book Value $ 30,000 24,000 14,400 8,640 5,184 1,728 0 ADS Method The ADS method recovery period for an asset class is equal to or greater than for the GDS method Often the ADS recovery period is equal to the class life (sometimes it is less) Asset is depreciated over the recovery period plus 1 year. First and last years are the SL rate (calculated based on the recovery period) ADS Example Given: Asset cost is $20,000 and has a class life of 4 years. The tax code specifies an ADS recovery period of 5 years. Year SL Factor Depreciation Book Value 1. 10 % 2. 20 % 3. 20% 4. 20% 5. 20% 6. 10% $2,000 4,000 4,000 4,000 4,000 2,000 $20,000 18,000 14,000 10,000 6,000 2,000 0 Business Taxes Businesses carry a large tax burden in our society. Businesses pay multiple types of taxes: Property taxes (applied to some personal property and land regardless of corporate profitability) Sales taxes (applied to items purchased) Excise taxes Income Taxes (usually the largest component and the one we will consider in our study) Economic Analysis Including Income Tax Considerations Most companies owe income taxes each year if they have a positive net income. Income taxes may be assessed locally and at the state level in addition to federal income taxes. Federal Income tax is the largest component of taxes. Taxes are expenses which reduce net income and cash flow. We want to gain an appreciation for cash flows and decision making both before and after the impact of income taxes. Income Tax Assessment Typically income taxes are calculated as a percentage of net income. Net income as defined here is gross revenues minus all qualifying pre-tax expenses, including depreciation. [Usually called net income before taxes (NIBT)] It turns out that state and local taxes deductible expenses and thus are part of the NIBT calculation Federal Tax Rates Simple Tax Example Estimated Tax Rate for Analysis Companies are likely subject to multiple income tax requirements (local, state, federal) Usually the Federal tax is largest It is common practice to use an "effective" income tax rate for evaluations rather than summing the impact of each rate. For example, we will typically say that the effective tax rate is 40% Effective Tax Rate Calculation Example Suppose the Federal tax rate is 34% Suppose the combined local and state taxes are 8% What is the effective combined tax rate? Recall that local and state taxes paid are deductible from income before federal taxes are paid. This in effect lowers the combined rate below their algebraic sum. Effective Tax Rate Calculation Example Effective Rate = 8% + 34% (1-8%) = 8% + 31.28% =39.28% After Tax MARR When we take taxes into account, the profit and cash flow to the company decreases. It is common for companies to perform before and after tax cash flows. Unless otherwise specified, a reasonable determination of the after tax MARR can be obtained from the before tax MARR as follows: MARR (after tax) = [MARR (before tax)]x(1 tax rate) After Tax Cash Flow In order to determine the after tax return on an investment, we must determine the after tax cash flow. The process begins by determining all cash flows just as before (revenues and out of pocket expenses) We then adjust the before tax cash flows to reflect expenses from depreciation of equipment It may also be necessary to include an additional expense (for tax purposes) if equipment is sold below book value before it is fully depreciated We then determine calculate the tax owed. The after tax cash flow is the before tax cash flow less the taxes owed. It is possible that depreciation causes a negative taxable income. In this case the taxes owed is a POSITIVE number which contributes in a positive way to the after tax cash flow. Basic Spreadsheet Basis $40,000 ; No Salvage Value; 4 yr SL Depreciation End of Year 0 1 2 3 4 BTCF (NIBT) -40,000 25,000 25,000 25,000 25,000 10,000 10,000 10,000 10,000 15,000 15,000 15,000 15,000 -6,000 -6,000 -6,000 -6,000 9,000 9,000 9,000 9,000 DEPR Taxable Income Income Tax (40%) Income After Tax* ATCF -40,000 19,000 19,000 19,000 19,000 * Optional Example Taxes and a "Cost" Cash Flow Initial Cost: $45,000 ; Salvage (4 yrs): $5,000 ; SL Depreciation End of BTCF Deprec Taxable Tax ATCF Yr Income (Savings) 40% 0 1 2 3 4 4 -$45,000 -15,000 -15,000 -15,000 -15,000 +5,000 0 -10,000 -10,000 -10,000 -10,000 0 0 -25,000 -25,000 -25,000 -25,000 0 0 +10,000 +10,000 +10,000 +10,000 0 -$45,000 -5,000 -5,000 -5,000 -5,000 +5000 Example A contractor has to choose between two alternatives for equipment: 1. Purchase a new truck ($13,000). The truck has a 7 yr useful life and an estimated salvage value of $3,000. The hourly expenses are $35 and the annual maintenance cost is $1,100. 2. Hire a rental piece of equipment for an all in cost of $83/day Using an after tax MARR of 10%, a 7 yr life, Straight Line Depreciation, and an effective 50% tax rate, how many days per year would the contractor need to use the equipment to justify the purchase? ...
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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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