Sequence _bbConcepts of

Depreciation and Taxes_

Engineering Economics

Dr. Hassan Ashraf

Engineering Economics _ CU Islamabad _ Wah Campus _ Civil
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Engineering Department
 Why Consider Taxes?
In general sense, taxes are a cost to a project, or to our personal cash
flow.

Students need to know how high the tax rates can become, and they
must appreciate the effects of taxation in their economic evaluations,
whether prospective or retrospective.

Taxes distort incentives. The buyer must pay more, while the seller
gets to keep less. Therefore, mutually beneficial, voluntary economic
transactions that would increase the overall wellbeing of the
economy would not occur. They become unprofitable and are a cost
to the economy. Thus price distortions are another component of the
total cost of government (Gwartney et al. 2010).

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 Why Consider Taxes?
The concepts we use to evaluate taxes on engineering projects also
apply to our personal tax reporting and financial decision making.
For example, when we learn how to amortize a loan, we can imagine
that it represents a home mortgage. We might also suggest that the
national debt should be considered to be mortgage, and the amount
of that debt is the present worth of discounted future taxes. We might
also distinguish between annual budget deficit and the total amount
of the debt.

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 Depreciation accounting for capital preservation

The fundamental idea is that profit and loss go together. The chance
to earn a profit also means the risk of earning loss. The only way to
determine whether you made a profit is with economic calculation
based on your specific knowledge. The Austrians believed that
ultimately an interventionist state would create economic chaos by
making economic calculation impossible. Without prices such a
society would operate in an information blackout, the result being
“planned chaos”.

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 Depreciation accounting for capital preservation

The major causes of price distortion have been inflation and

taxation. Specifically, inflationary effects can make a loss appear to
be a profit. We can partially overcome these effects by accounting
for allowable depreciation. Therefore, know how to calculate
depreciation deductions, and be able to estimate resulting effects in
taxes due.

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 Depreciation accounting for capital preservation

We make the distinction between physical (wear and tear)

depreciation and the methods of bookkeeping, or accounting,
depreciation. Our objective is to recover the value lost or used in the
work so that capital value is not consumed by taxes and inflation.

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 Questions that are asked

What are the present values of the depreciation tables for SL and
MACRS accounting methods?

What is the present value of taxes required to be paid, or what is the

present value of the tax savings resulting from depreciation for both
SL and MACRS methods?

What would happen if you were to sell equipment for more than its
book value at some time prior to the final year of the accounting
period?

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 Estimating the effects of Taxation

Our major concern is to be able to convert pre-tax cash flow into an

after-tax cash flow. In addition to the basic interest factor equations,
we will consider marginal tax rates, depreciation, interest payments,
and inflation. We want an after-tax cash flow incorporating all these
concerns to use in our decision rule to determine how best to proceed
with our particular project.

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 Estimating the effects of Taxation

Taxes are calculated on the actual, or current, money amounts.

Therefore, an actual dollar analysis is required; any money amounts
expressed in constant or base-years units (dollars) must first be
converted to current, actual amounts before taxes can be calculated.
Then, after accounting for anticipated taxes, the before-tax cash flow
can be converted to an after-tax cash flow for evaluation. One could
convert this actual dollar after-tax cash flow to a constant dollar
after-tax flow for analysis, if desired. Of course, knowledge of a
year-by-year rate of inflation would be required for this conversion.

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 Estimating the effects of Taxation

When dealing with taxation in inflationary environment, one must be

explicit about what the acceptable minimum attractive rate of return,
or prevailing interest rate, refers to: is it after-tax, actual, or constant
dollar based? The result of moving from an imaginary world of no
inflation or taxation into real world with taxes and inflation is
examined in the following example.

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 Estimating the effects of Taxation

We are considering a purchase of equipment with initial price of

$20,000 and zero salvage value after a three-year life. We expect a
constant dollar income of $9,000 per year. The required minimum
attractive rate of return (I’) in the constant dollar domain is 8%
annually. Inflation is anticipated to average 5% annually. Should we
make this acquisition when the expected tax rate is at 38%?

Begin with the no tax, no inflation case:

Net P = NPV @ 8% = -20,000 + 9000* (P/A,8%,3)

= -20,000 + 9000 * (2.577)
= -20,000 + 23,193
= + $3,193
Therefore, the acquisition is profitable.

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 Estimating the effects of Taxation
(b) Considering the effect of taxation only

Tax is applied on income. So, if the income is 9,000 amount after tax
will be = 9,000 x 0.62 = $5,580

NPV @ 8% = -20,000 + 5580 * (P/A, 8%,3) = -$5619

So, now the investment would not be profitable.

(c) Considering both Depreciation and Taxation

The Asset’s Book Value is 20,000.

Useful life that we will be considering in this problem is 3 years

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 Estimating the effects of Taxation

Therefore, using the straight-line method, the depreciation for the

asset can be calculated as:

= Book Value/ Useful life of the Asset

= 20,000/3

= 6,666.67

Depreciation is treated as an expense and therefore should be

subtracted from the income so that amount of taxable income
becomes less and consequently the final tax amount.

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 Estimating the effects of Taxation

Therefore, using the equation

Revenue – Expense = Profit/Income

9,000 – 6,666.67 = 2,333.33

So the amount of taxable income is 2,333.33

Now, on this amount the tax rate of 38% will be applied

0.38 x 2,333.33 = 886.66

So, the amount expected to be paid in taxes is $ 888.66

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 Estimating the effects of Taxation

The Net income left after paying taxes is = 9,000 – 886.66

= $8113.34

NPV @ 8%= -20,000 + 8113.34 * (P/A, 8%, 3)

= -20,000 + 8113.34 * (2.577)

=-20,000 + 20,908.1

= +$908

Now, the investment is profitable again!

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 Estimating the effects of Taxation

(d) Finally, we approach the “real world” of 5% annual inflation and

38% marginal taxation. The following table shows the sequence of
calculations necessary to evaluate the proposed investment. The
columns are as follows:
A(years); A (constant dollar amounts); A’ ( actual, inflated dollar
amounts); D (depreciation); A;-D ( actual dollar taxable amounts); T’
(tax0; F’ (actual dollar after tax amounts); and F (deflated, constant
dollar after-tax amounts).

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 Estimating the effects of Taxation
T Cashflow Inflated Deprecia Inflated 38% tax Income Deflated
Values Cashflow tion Cashflow on After Tax Values of
Values - Taxable Income
Deprecia income After Tax
tion
0 -20,000 -20,000 -20,000

1 +9,000 9450 6667 2783 1058 8392 7992

2 +9,000 9923 6667 3256 1237 8686 7878

3 +9,000 10,419 6667 3752 1426 8993 7768

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 Estimating the effects of Taxation

Discounting F ( constant dollar amounts) at 8% annually by

repeated application of Eq. 3.1 gives NPV@8% = +$320. Would
this investment be made?

I ask the students why this is not good for everyone involved.
However, when we investigate the situation using deflated
(constant) dollars, we see that the effect of inflation has essentially
eliminated the attractiveness of the investment by devaluing the
anticipated future after-tax income. The “real” value has been
virtually destroyed.

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 Summary of effects of inflation
Above example demonstrates several effects, as its is augmented
stepwise from the imaginary, “no tax no inflation” world to the “real
world.”

(a) In the basic untaxed, non-inflationary example, the project

specified exhibited a positive net present value, thus making it a
worthwhile investment.

(b) When taxed at a marginal rate above 13.8%, found from an internal
rate of return calculation, the project (still without any inflation
effect) would have a negative net present value making it a poor
investment that would not be made.

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 Summary of effects of inflation
(c) Incorporating SL depreciation of the equipment purchased (still
without any inflation effect) made the acquisition worthwhile, even at
38% tax rate, but its “profitability” shown by the net present value was
substantially reduced from case (a).

(d) When modest inflation (5% annual) was added, even with
depreciation included, the net present value was reduced nearly to zero,
compared to case (c).

We should remind the students that all of these example calculations

are prospective and the realized net present value would only be known
after the fact by retrospective calculation.

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Depreciation Methods

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 Declining balance Methods

The second concept recognizes that the stream of services provided by

a fixed asset may decrease over time; in other words, the stream may
be greatest in the first year of an asset’s service life and least in its last
year. This pattern may occur because the mechanical efficiency of an
asset tends to decline with age, because maintenance costs tend to
increase with age, or because of the increasing likelihood that better
equipment will become available and make the original asset obsolete.
This reasoning tends to a method that charges a larger fraction of the
cost as an expense of the early years than of the later years. This
method, the declining-balance method, is the most widely used.

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 Declining balance Methods
Depreciation rate

The declining-balance method of calculating depreciation allocated a

fixed fraction of the beginning book balance each year. The fraction
alpha is obtained from the straight line method depreciation rate
(1/N) as a basis:

Alpha = (1/N) (multiplier)

The most commonly used multipliers in the United States are 1.5
( called 150% DB) and 2.0 (called 200% DDB, or double declining
balance). So, a 200% DB method specifies that the depreciation rate
will be 200% of the straight-line rate. As N increases, alpha
decreases, thereby resulting in a situation in which depreciation is
highest in the first year and then decreases over the asset’s
depreciable life.
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 Declining balance Methods

Declining-Balance Depreciation

Consider the following accounting information for a computer

system:

Cost basis of the asset (I) = $10,000

Useful life (N) = 5 Years

Estimated Salvage Value (S) = $2,000

Compute the annual depreciation allowances and the resulting book

values using the double-declining-balance depreciation method.

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 Declining Balance Methods
End of Dn Bn
Year
1 0.4 (10,000) = 4,000 10,000-4000=6,000

2 0.4 (6,000) = 2,400 6,000-2,400=3,600

3 0.4 (3,600) = 1,440 3,600-1440=2160

4 0.4 (2,160) = 864 but here the 2160-160=2000

value of 160 above 2,000 dollars
threshold value will be used

5 0 2000-0=2000

Total 8,000
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 Switching Policy
When Bn > S, we are faced with a situation in which we have not
depreciated the entire cost of the asset and thus have not taken full
advantage of depreciation’s tax deferring benefits. If we would prefer
to reduce the book value of an asset to its salvage value as quickly as
possible, we can do so by switching from DB depreciation to SL
depreciation whenever SL depreciation results in higher depreciation
charges and, therefore, a more rapid reduction in the book value of
the asset. The switch from DB to SL depreciation can take place in
any of the n years, the objective being to identify the optimal year to
switch. The switching rule is as follows: if DB depreciation in any
year is less than (or equal to) the depreciation amount calculated by
SL depreciation on the basis of the remaining years, switch to and
remain with the SL method for the duration of the asset’s depreciable
life. The straight –line depreciation in any year n is calculated as:

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 Switching Policy

Dn = Book value at beginning of year n – Salvage value/ Remaining useful life at beginning
of year n

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Declining Balance with Conversion to Straight-Line
Cost basis of the asset (I)= $10,000
Useful life (N) = 5 Years
Salvage value (S) = $0

Alpha = (1/5) (2) = 40%

Determine the optimal time to switch from DB to SL depreciation and the

resulting depreciation schedule.

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Declining Balance with Conversion to Straight-Line
n Without Book Value n With Switching to Book Value
switching SL Depreciation
Depreciation
1 10,000 (0.4) 6000 1 4,000 6,000
= 4,000
2 6,000 (0.4) 3600 2 6,000/4=1,500<2,400 3600
=2,400
3 3,600 (0.4) 2160 3 3,600/3=1,200<1440 2160
=1,440
4 2160(0.4) 1296 4 2160/2=1080>864 1080
=864
5 1296(0.4) 778 5 1080/1=1080>518 0
=518

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 Units-of-Production Method

Straight-line depreciation can be defended only if the fixed asset –

say, a machine- is used for exactly the same amount of time each year.
What happens when a punch-press machine is run 1,670 hours one
year and 780 the next, or when some of its output is shifted to a new
center? This situation leads us to consider another depreciation
concept that views the asset as a bundle of service units rather than as
a single unit as in the SL and DB methods. However, this concept
does not assume that the service units will be consumed in a time-
phased pattern. The cost of each service unit is the net cost of the
asset divided by the total number of such units.

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 Units-of-Production Method
The depreciation charge for a period is then related to the number of
service units consumed in that period. This definition leads to the units-
of-production method. By this method, the depreciation in any year is
given by

Dn = Service units consumed during year n / Total service units (I – S)

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 Units-of-Production Method
A truck for hauling coal has an estimated net cost of $55,000 and is
expected to give service for 250,000 miles, resulting in a $5,000
salvage value. Compute the allowed depreciation amount for truck
usage of 30,000 miles.

Given I = 55,000, S = 5,000, total service units = 250,000 miles and

usage for this year = 30,000 miles

The depreciation expense in a year in which the truck traveled 30,000

miles would be

= 30,000/250,000 (55,000-5,000) = (3/25) (50,000) = 6,000.

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 MACRS

Prior to Economic Recovery Act of 1981, taxpayers could choose

among several methods when depreciating assets for tax purposes.
The most widely used methods were the straight-line method and the
declining-balance method. The subsequent imposition of the
accelerated cost recovery system (ACRS) and the modified
accelerated cost recovery system (MACRS) superseded these methods
for use in tax purposes. Currently, the MACRS is the method used to
determine the allowed depreciation amount in the calculation of
income taxes.

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 MACRS Recovery Periods

Historically, for tax purposes as well as for accounting, an asset’s

depreciable life was determined by its estimated useful life; it was
intended that an asset would be fully depreciated at approximately the
end of its useful life. With the MACRS scheme, however, accountants
totally abandoned this practice, and simpler guidelines were set that
created several classes of assets, each with a more or less arbitrary
life span called a recovery period. ( Note: These recovery periods
do not necessarily correspond to expected useful lives).

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MACRS Property Classifications (ADR Depreciation
Range)

ADR = Asset Depreciation Range

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 MACRS Depreciation : Personal Property

Prior to 1986, the rate at which the value of an asset actually declined
was estimated, and this rate was used for tax depreciation. Thus
different assets were depreciated along different paths over time. The
MACRS method, however, establishes prescribed depreciation rates,
called recovery percentages, for all assets within each class. The
rates, as set forth in 1986 and 1993, are shown in table.

We determine the yearly recovery, or depreciation expenses, by

multiplying the asset’s depreciation base by the applicable recovery-
allowance percentage:

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 MACRS Depreciation : Personal Property

Half-Year convention: The MACRS recovery percentages use the

half-year convention; that is, it is assumed that all assets are placed in
service at midyear and that they will have zero salvage value. As a
result, only a half year of depreciation is allowed for the first year
that property is placed in service. With half of one year’s depreciation
being taken in the first year, a full year’s depreciation is allowed in
each of the remaining years of the asset’s recovery period, and the
remaining half-year’s depreciation is incurred in the year following
the end of the recovery period. A half-year of depreciation is also
allowed for the year in which the property is disposed of, or is
otherwise retired from service, any time before the end of the
recovery period.

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 MACRS Depreciation : Personal Property

Switching from the DB method to the SL method: The MACRS asset

is depreciated initially by the DB method and then by the SL method.
Consequently, the MACRS scheme adopts the switching convention:

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MACRS Depreciation schedules for Personal
Property with Half –Year convention

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 MACRS Guidelines

• Farm Buildings, municipal sewers, sewer pipes, and certain other

vey long-lived equipment are written off over 20 years by 150%
DB and then by switching to SL depreciation.

• Investments in residential rental property are written off in a

straight-line fashion over 27.5 years. On the other hand, non-
residential real estate ( commercial buildings) is written off by the
SL method over 39 years.

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An old automobile is traded for a new automobile with a list price of
30,000. The old automobile has a net book value of 5,000, but the
dealer has given 6,000 trade-in allowance, so the total purchase price
is 24,000. Determine the optimal time to switch from DB to SL
depreciation and the resulting depreciation schedule.

Given: Five-year asset, S =0

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 MACRS Depreciation: Personal Property with Trade-In

a) Cost basis with trade-in allowances:

Cost basis = Cash paid + Book Value

= 24000+ 5000
= 29,000

b) We can calculate the depreciation amounts using the percentages

taken directly from table presented above.
20% 32% 19.20% 11.52% 11.52% 5.76%
5,800 9280 5568 3341 3341 1670
Full Full Full Full
1 2 3 4 5 6

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 MACRS Depreciation: Real Property

Residential real property with cost basis = 80,000;

Find: the depreciation in each of the 10 tax years the property was in service

In this example, the midmonth convention assumes that the property is placed in
service on May 15, which gives 7.5 months of depreciation in the first year.
Remembering that only the building (not the land) may be depreciated, we compute
the depreciation over a 27.5 year period using the SL method:

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 bb

Thank You

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