MSE604 Ch. 7 - Decpreciation & Income Taxes

8/19/2019 MSE604 Ch. 7 - Decpreciation & Income Taxes

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Copyright ©2012 by Pearson Education, Inc.

Upper Saddle Rier, !e" #ersey 0$%&' (ll rights resered.

Engineering Economy , )i*teenth Edition+y illia- . Sullian, Elin /. ics, and C. Patric oelling

Engineering Economy

Chapter 7: Decpreciation and Income

Taxes


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The objective of Chapter 7 is toexplain how depreciation affects

income taxes, and how incometaxes affect economic decision

maing!


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Income taxes "s"ally represent a

significant cash o"tflow! In thischapter we describe how after tax

liabilities and after#tax cash flowsres"lt in the after-tax cash flow

$%TC&' procedure! Depreciation

is an important element in

finding after#tax cash flows!


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Depreciation is the decrease in val"e of

physical properties with the passage oftime!

( It is an acco"nting concept, a non-cash cost,

that establishes an ann"al ded"ction against before#tax income!

( It is intended to approximate the yearly

fraction of an asset)s val"e "sed in the prod"ction of income!


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*roperty is depreciable if

( it is "sed in b"siness or held to prod"ceincome!

( it has a determinable "sef"l life, longer than

one year!( it is something that wears o"t, decays, gets

"sed "p, becomes obsolete, or loses val"e

from nat"ral ca"ses!( it is not inventory, stoc in trade, or

investment property!


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Depreciable property is

( tangible $can be seen or to"ched+ personal

or real' or intangible $s"ch as copyrights,

patents, or franchises'!( depreciated, according to a depreciation

sched"le, when it is p"t in service $when it

is ready and available for its specific "se'!


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traight line $-': constant amo"nt of

depreciation each year over the

depreciable life of the asset!

( N . depreciable life

( B . cost basis( d k . depreciaton in k

( BV k . boo val"e at

end of k

( SV N . salvage val"e


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%cme p"rchased a coordinate meas"rement

machine $C//'! The cost basis is 0123,333 and it

has a seven year depreciable life! %cme estimates asalvage val"e of 022,333 at the end of seven years!

Determine the ann"al depreciation amo"nts "sing

- depreciation! Tab"late the ann"al depreciation

amo"nts and boo val"e of the C// at the end ofeach year!

*a"se and solve


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Declining#balance $D4': a constant#

percentage of the remaining 45 isdepreciated each year!

The constant percentage is determined by R,

where R . 2/N when 2336 declining balance is

being "sed, R = 1.5/N when 136 declining

balance is being "sed!


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The units-of-production method can be

"sed when the decrease in val"e of theassset is mostly a f"nction of "se, instead

of time! The cost basis is allocated

e8"ally over the n"mber of "nits prod"ced over the asset)s life! The

depreciation per "nit of prod"ction is

fo"nd from the form"la below!


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The odified !ccelerated "ost Reco#er$S$ste% $/%C9' is the principle

method for comp"ting depreciation for

property in engineering projects! Itconsists of two systems, the main system

called the &eneral 'epreciation S$ste%

$D' and the !lternati#e 'epreciationS$ste% $%D'!


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;hen an asset is depreciated "sing

/%C9, the following information isneeded to calc"late ded"ctions!

( Cost basis, B

( Date the property was placed into service

( The property class and recovery period

( The /%C9 depreciation method $D or

%D'!

( The time convention that applies $half year'


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There are many different types of taxes!

( Income taxes are assessed as a f"nction of grossreven"es min"s allowable expenses!

( *roperty taxes are assessed as a f"nction of the

val"e of property owned!( ales taxes are assessed on the basis of p"rchase

of goods or services!

( Excise taxes are federal taxes assessed as a

f"nction of the sale of certain goods or servicesoften considered nonnecessities!

;e will foc"s on income taxes!


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Taing taxes into acco"nt changes

o"r expectations of ret"rns on projects, so o"r /%99 $after#tax' is

lower!


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Engineering Economy , )i*teenth Edition

+y illia- . Sullian, Elin /. ics, and C. Patric oelling

The after#tax /%99 sho"ld be at least

the tax#adj"sted weighted average cost of

capital $;%CC'!

λ . fraction of a firm)s pool of capital borrowed from lenders

t . effective income tax rate as a decimal

i( . before#tax interest paid on borrowedcapital

ea . after#tax cost of e8"ity capital


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Depreciation is not a cash flow, b"t it

affects a corporation)s taxable income, andtherefore the taxes a corporation pays!

Taxable income . gross income

? all expenses except capital invest!

? depreciation ded"ctions!


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&ederal taxes are calc"lated "sing a set

of income bracets! each applying a

different tax rate on the marginal val"eof income! tate taxes vary widely!

( Tax rates are fo"nd in Table 7#!

( Corporations need to now their effecti#e tax rate,

which is a combination of federal and state taxes

according to either form"la below!


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-ast year %cme, Inc! had 01@!A million in reven"e, 01!2

million of operating expenses, and depreciation expenses of

0!A million!


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The disposal of a depreciable asset can

res"lt in a gain or loss based on the sale price $maret val"e' and the c"rrent boo

val"e

% gain is often referred to as depreciation recapture,

and it is generally taxed as the same as ordinaryincome! % loss is a capital loss! %n asset sold for

more than it)s cost basis res"lts in a capital )ain!


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%cme Casting and /olding sold a piece of e8"ipment

d"ring the c"rrent tax year for 0@7,333! This e8"ipment had

a cost basis of 0213,333 and the acc"m"lated depreciation

was 01>,333! %ss"me the effective income tax rate is A36!4ased on this information, what is

a!the gain $loss' on disposal,

b!the tax liability $or credit' res"lting from this sale, and

c!the tax liability $or credit' if the acc"m"lated depreciationwas 012,333 instead of 01>,333B

*a"se and solve


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%fter#tax economic analysis is

generally the same as before#taxanalysis, j"st "sing after#tax cash

flows $%TC&' instead of before#tax cash flows $4TC&'! The

analysis is cond"cted "sing the

after#tax /%99!


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Cash flows are typically determined for

each year "sing the notation below! Rk . reven"es $and savings'from the project d"ring period k

* k . cash o"tflows d"ring k for ded"ctible expensesd k . s"m of all noncash, or

boo, costs d"ring k , s"ch asdepreciationt . effective income tax rate onordinary income+ k . income tax conse8"enced"ring year k

!+", k .%TC& from the project d"ring year k


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ome important cash flow form"las!

Taxable income

rdinary income tax conse8"ences


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Insert &ig"re 7#A on this slide


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%cme p"rchased a p"mp for 023,333 and

expended 023,333 for shipping andinstallation! The addition of this p"mp will

res"lt in an increase in reven"e of 03,333,

with associated increased expenses of

013,333, each year! The p"mp has a D

recovery period of five years, and %cme)s

effective tax rate is A16! ;hat is the %TC&

for this project for the fo"rth year of serviceof the assetB


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Economic val"e added, E5%, is an

estimate of the profit#earning potential of

proposed capital investments in

engineering projects! It is the difference

between a company)s adj"sted net

operating profit after taxes $*%T' in a

partic"lar year and its after#tax cost of

capital d"ring that year!


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where,

and


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Upper Saddle Rier, !e" #ersey 0$%&'(ll rights resered



&or %cme, what is the E5% for year A if

their after#tax /%99 is 6B

MSE604 Ch. 7 - Decpreciation & Income Taxes

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