Lecture # 8 Depreciation II

8/12/2019 Lecture # 8 Depreciation II

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Lecture # 8

Cost Estimation

1. Depreciation – part 2

2. Depletion

16-1Dr A Alim



Case Study # 1

Students will form three teams.

Each team will work on the following problem:

AFTER-TAX EVALUATION FOR BUSINESS EXPANSION.

Blank’s Book, 7th ed., Page 482 (end of chapter 17)

It is helpful to also read section 10.5 in chapter 10 of the book (page 275).

Answer questions 1 to 4 (Question 4 asks you to determine the AW of EVA)

Note that the after tax MARR is 10%.



Definition of terms when both debt and equity financing are involved:

1) Debt investment is a loan and is not included in determining the value of P.

This can be readily seen for year zero:

P = CF out - CF in

= Total capital invested – loan amount

= (loan amount + equity investment) – loan amount

= equity investment

2) It is important to know that as a result, the rate of return on capital invested refers

to return on equity investment only. A small equity investment results on a relatively

large rate of return.

3) CFBT = GI – E – equity investment + salvage value – (loan principal + loan interest)

4) Loan interest (but not principal) is tax deductible. Therefore:

TI = GI – E – D – loan interest

5) CFAT = CFBT – TI(te)



Expectations from each team

The team will work as a group. Each team member must be involved in preparation and

presentation.

Each team will elect a team leader (I need the team leaders’ names today).

Each team will make a PowerPoint presentation to the rest of the class and provide me with acopy of their presentation. Presentations will be on Tuesday, February 18, 2014.

The presentation will cover:

* Clear definition of the problem, what is given and what is asked* Theory and basic equations involved.* Solution strategy.* Assumptions made and sources of data needed.* Solution to the problem.

A list of the students actually presenting must be submitted atthe beginning of each presentation. Students not presenting will not receive a grade for thisproject.

Each team is fully responsible for bringing and testing their lap tops, cables, etc.



Switching between depreciationmethods

Because the DDB method may or may not reach theestimated salvage value , It is allowed in some countriesand in some US states to switch to SL method near theend of the recovery period in order to reach the estimatedS, and maximize tax advantage.

In the US, the MACRS method is based on this logic.Starting with DDB then switching to SL with S value ofzero.

The goal is to maximize the present value of accumulateddepreciation:

PWD = Σ Dt (P/F, i %, t)………for t =1 to n

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 7th Edition, 2012 16-5 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved









Switching between depreciation methodsBlank, 7th ed. Examples 16A.3 ( p. 433 ) , 16A.4 ( p. 435 )

Blank, 6th ed. Examples 16A.2 ( p. 559 ) , 16A.3 ( p. 562 )



(You may assume S = 0)





























Example 16A.3, part (d) is in the homework.







Switching between depreciation

methods (Application)The MACRS method is based on a switch from DDB toSL:• Applying all the rules mentioned earlier

• And allowing for the half year convention

Reading assignment:

Read the following in Blank’s book (7th ed.):

Section 16A.3, page 435. Examples 16A.5 and 16A.6 illustratehow the MACRS rates are derived by applying DDB-SL switch.





Depletion

Depreciation is applied to assets that can bereplaced.

Depletion applies to resources that are noteasily replaced, and are depleted with usage:

Timber,

Mineral deposits, Oil and gas,

etc.





Two methods to calculate depletion

Cost Depletion Also 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 thefirm’s current taxable income.





DEPLETION: Cost Depletion

First, the cost basis of theresource is determined – firstcost or investment cost.

Second – one must estimatethe amount of the resource thatis available for extraction. Termed: Resource Capacity. It is an estimated value

since it is impossible topredict exactly the trueresource capacity!

Then, cost depletion factor p t

for year t is calculated …

If the original resource capacity

is re-estimated in the future, anew p t is recalculated.

Let t denote the year p t denotes the depletion

factor for year t

Then, pt is defined as:

For year “t”: Depletion ($)

= P t x resource amount

extracted in this yea.

first cost

resource capacityt

p



DEPLETION C M h d



DEPLETION: Cost MethodExample

Example 16.5, page 428, Blank (7th ed.)













DEPLETION: Cost depletion

Major Point for cost depletion:There must be a reasonable estimate

of the amount of the resource that isbeing extracted.

For firms engaged in extractionactivities the process of resourceestimation is an important activity

and requires expert analysis.






Economy, 7th Edition, 2012

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved16-25

Percentage Depletion

• An alternative method for natural resource extraction activities

• A constant stated percentage of the resources gross income may bedepleted each year so long as the calculated depletion amount doesnot exceed 50% of the firm’s net taxable income (Defined as GI – E),

i.e. before the depletion deduction is taken !

• Allowable depletions rates are published by the IRS

• THEREFORE: The % depletion allowance is the smaller of the

calculated amount and 50% of the net “taxable income” in the given

year, i.e. 0.5(GI-E)



DEPLETION: Percentage Method

Deposit Percentage

Sulfur, uranium,

lead, nickel , zinc 22%

Gold, silver ,copper,iron ore andgeothermal deposits

15%

Oil and gas wells(varies)

15-22%

Coal, lignite, sodiumchloride

10%

Gravel, sand, peat,stone

5%

Most other minerals 14%

Note:

Due to frequentrevisions of theUS Federal taxcode, the analystshould alwaysrefer to the latestpublished rates!











Depletion Law Requirement

The current law:The law allows taking the larger of the costdepreciation and the % depreciations in agiven year.

This means that one should apply both methods inthe beginning, and take the larger depreciation.



Depletion Law Requirement – (Engineering Economics, 4th ed.,Prentice Hall, 2007.



Depletion Law Requirement (Engineering Economics, 4 ed.,Prentice Hall, 2007.

By C.S.Park, example 9.11 p. 455)

16-30© 2007 by Prentice Hall, All Rights Reserved



16-31© 2007 by Prentice Hall, All Rights Reserved



16-32 © 2007 by Prentice Hall,

All Rights Reserved




Economy, 7th Edition, 2012

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved16-33

CHEE 5369/6369

Homework # 3

Thursday February 6, 2014

The following solved examples from Blank (7th):

Example 16.1 page 418

Example 16.3 page 421

Example 16A.1 page 430

Example 16A.3(d) page 434



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Lecture # 8 Depreciation II