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EGR 312 - 241 Depreciation Depreciation the reduction in value of an asset. Used to reflect remaining value of an asset over its useful life. Book Depreciation used by corporations for internal financial accounting Tax Depreciation use in tax calculations in accordance to government regulations

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EGR 312 - 242 Why is depreciation important? Depreciation can lower your taxes: taxes = (income deductions)*tax rate where one of the primary deductions is depreciation. In other words, the use of depreciation can make you money by reducing the amount of taxes you pay.

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EGR 312 - 243 Definitions First Cost cost of purchasing and installing an asset (on real-estate, the value of land is excluded) Book Value the remaining, undepreciated capital of an asset which is on the corporations books; the first cost minus the sum of all deprecation taken Recovery Period depreciable life of the asset in years Market Value estimate of the value of an asset if sold on the open market, not necessarily the same as the book value.

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EGR 312 - 244 Definitions Depreciation Rate the fraction of the First Cost removed by depreciation each year. Personal Property allowed for depreciation, includes items such as manufacturing equipment, vehicles, computers, etc. Real Property also allowed for depreciation, includes office buildings, warehouses, manufacturing facilities, etc note, land is not depreciated. Half-year convention assumes assets are placed in service in midyear.

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EGR 312 - 245 Straight Line (SL) Depreciation Book value depreciates linearly with time. In other words, depreciation is removed in equal amounts each year. Where t = year (1,2, n) D t = annual depreciation charge B = first cost S = estimated salvage value n = recovery period d = depreciation rate = 1/n

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EGR 312 - 246 SL Depreciation Book value (SL): Depreciation rate is constant:

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EGR 312 - 247 SL Depreciation Example: A $20,000 vehicle is to be depreciated over 7 years using SL depreciation.

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EGR 312 - 248 Declining Balance (DB) Depreciation Book value depreciates by a fixed percentage of the book value, not a fixed amount. Where t = year (1,2, n) BV t-1 = book value in year t - 1 D t = depreciation amount in year t d = depreciation rate

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EGR 312 - 249 DB Depreciation Example: A $20,000 vehicle is to be depreciated over 7 years using DB depreciation with a depreciation rate of 0.25.

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EGR 312 - 2410 Double Declining Balance (DDB) Depreciation The maximum annual depreciation rate for DB method is: d max = 2/n In this case, the method is called double declining balance (DDB)

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EGR 312 - 2411 Modified Accelerated Cost Recovery System (MACRS) MACRS is the US government accepted depreciation schedule for tax purposes. MACRS combines facets of DDB and SL methods. Assets are grouped into categories based on recovery periods of 3, 5, 7, 10, 15, 20, 27.5, and 39 years. See table 16-4, pg. 546 for asset groupings. Examples: landscaping around the UC rental house tooling for new line of refrigerators

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EGR 312 - 2412 MACRS To determine the amount of deprecation each year, use the following depreciation rate table (table 16-2, pg. 542.)

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EGR 312 - 2413 MACRS Example: A $20,000 vehicle is to be depreciated for tax purposes.

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EGR 312 - 2414 After-Tax Economic Analysis Gross Income (GI) total income realized from all revenue-producing sources, including items such as the sales of assets, royalties, license fees, etc Income Tax amount of taxes based on gross income. Corporate taxes are typically paid quarterly, and are actual cash flows. Operating Expenses (E) all corporate costs incurred in the transaction of business.

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EGR 312 - 2415 After-Tax Economic Analysis Taxable Income (TI) the amount upon which taxes are based. TI = ______________ Where D is depreciation defined in previous lecture. Tax Rate (T) percentage of TI owed in taxes. This rate is graduated, based on TI. (See table 17-1) Net Profit after taxes (NPAT) amount remaining each year when income taxes are subtracted from taxable income. NPAT = _____________

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EGR 312 - 2416 After-Tax Economic Analysis Corporate Federal Income Tax Rate Schedule (2003) TI LimitsTI RangeTax Rate T Maximum Tax for TI Range Maximum Tax Incurred $1-$50,000$50,0000.15$7,500 $50,001-$75,00025,0000.256,25013,750 $75,001-$100,00025,0000.348,50022,250 $100,001-$335,000235,0000.3991,650113,900 $335,001-$10 mil9.665 mil0.343.2861 mil3.4 mil over $10 - $15 mil5 mil0.351.75 mil5.15 mil over $15 - $18.33 mil3.33 mil0.381.267 mil6.417 mil over $18.33 milunlimited0.35unlimited Graduated tax rate schedule (table 17-1, pg. 571)

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EGR 312 - 2417 After-Tax Economic Analysis Average Tax Rate because the marginal tax rate varies as TI varies, the average tax rate is calculate as: Ave tax rate = total taxes / TI Effective Tax Rate (T e ) the total rate paid by corporations, including federal, state and local taxes. Note state taxes can be deducted from federal taxes. So: T e = state rate + (1-state rate)( federal rate)

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EGR 312 - 2418 Example: Problem 17.5 a) Average Tax Rate Taxes on $300,000 = ____________________ Ave tax rate = _______________________ Effective Tax Rate (assume state tax = 7% T e = ______________________________

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EGR 312 - 2419 CFBT vs CFAT Cash flow before tax (CFBT) all cash flows throughout the year without considering taxes. Note, all our PW, FW, AW analysis to this point have been CBFT cash flows. CFBT = GI E P + S where P is initial investments and S is salvage. Cash flow after tax (CFAT) includes the cash flow impact of taxes. CFAT = CFBT - taxes

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EGR 312 - 2420 CFBT vs CFAT Knowing CFAT = CFBT taxes Taxes are calculated taking depreciation (D) into account, however depreciation is not a cash flow, but taxes are. Taxes = TI(T e ) TI = GI E D CFAT = GI E P + S (GI E D)(T e )

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EGR 312 - 2421 After-Tax Economic Analysis Example 17.3 from Book Cash Flow Before Taxes YearGIEP and SCFBT 0($550,000) 1$200,000($90,000)$110,000 2$200,000($90,000)$110,000 3$200,000($90,000)$110,000 4$200,000($90,000)$110,000 5$200,000($90,000)$110,000 6$200,000($90,000)$150,000$260,000 Total$260,000 Cash Flow After Taxes YearGIEP and SDTITaxesCFAT 0($550,000) 1$200,000($90,000)$110,000$0 $110,000 2$200,000($90,000)$176,000($66,000)($23,100)$133,100 3$200,000($90,000)$105,600$4,400$1,540$108,460 4$200,000($90,000)$63,360$46,640$16,324$93,676 5$200,000($90,000)$63,360$46,640$16,324$93,676 6$200,000($90,000)$150,000$31,680$78,320$27,412$232,588 Total$550,000$221,500

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EGR 312 - 2422 Definitions Capital Gains (CG): Occurs when selling price is greater than first cost. Capital gain = selling price first cost CG = SP P Depreciation Recovery (DR): Occurs when a depreciable asset is sold for more than the current book value. Depreciation recapture = selling price book value DR = SP BV t Capital Loss (CL): Occurs when a depreciable asset is disposed of for less than its current book value. CL = BV t - SP

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EGR 312 - 2423 After-Tax Economic Analysis $0 BV P SP DR CG When selling price exceeds first cost then both a capital gain and a depreciation recovery occur. $0 BV SP P DR When selling price exceeds book value but is less than he first cost then a depreciation recovery occurs.

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EGR 312 - 2424 After-Tax Economic Analysis $0 SP BV P CL When selling price is below book value a capital loss occurs.

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EGR 312 - 2425 After-Tax Economic Analysis Considering capital gains, depreciation recovery and capital losses, TI = gross income expenses depreciation + depreciation recapture + capital gains capital loss TI = GI E D + DR + CG - CL

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EGR 312 - 2426 Relationship between before-tax MARR and after- tax MARR: Before-tax MARR = T e for corporations is often between 30 and 50%. After-Tax PW and AW Analysis After-tax MARR 1 - T e

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EGR 312 - 2427 After-Tax PW and AW Analysis Approach 1: Find the PW or AW of an alternative using the CFAT and the After-tax MARR. That alternative with the largest PW (AW) is chosen. Note, PW must use LCM (least common multiple of years.)

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EGR 312 - 2428 After-Tax Economic Analysis Using cash flows from Example 17.3, and an after-tax MARR of 7%, the PW of this alternative is: PW = - $550,000 + $110,000(P/F, 7%, 1) + $133,100(P/F, 7%, 2) + $108,460(P/F, 7%, 3) + $ 93,676(P/F, 7%, 4) + $ 93,676(P/F, 7%, 5) + $232,588(P/F, 7%, 6) = ______________ YearCFAT 0($550,000) 1$110,000 2$133,100 3$108,460 4$93,676 5 6$232,588 Total$221,500