Lecture6 2018

Engineering Economy
Lecture 6
Depreciation and Income Taxes - Chapter 7
Engineering Economy
Income Taxes
Income taxes usually represent a significant
cash outflow. In this chapter it is described
how after tax liabilities and after-tax cash flows
result in the after-tax cash flow (ATCF)
procedure. Depreciation is an important
element in finding after-tax cash flows.
Engineering Economy
Depreciation
Depreciation is the decrease in value of
physical properties with the passage of
time.
It is an accounting concept, a non-cash cost,
that establishes an annual deduction
against before-tax income.
It is intended to approximate the yearly
fraction of an asset’s value used in the
production of income.
Engineering Economy
Property is depreciable if…
it is used in business or held to produce income.
it has a determinable useful life, longer than
one year.
it is something that wears out, decays, gets
used up, becomes obsolete, or loses value from
natural causes.
it is not inventory, stock in trade, or investment
property.
Engineering Economy
Depreciable property is …
tangible (can be seen or touched; personal or
real) or intangible (such as copyrights, patents,
or franchises).
depreciated, according to a depreciation
schedule, when it is put in service (when it is
ready and available for its specific use).
Engineering Economy
Some definitions
Basis or Cost basis: The initial cost of acquiring
an asset (purchase price + sales taxes, including
transportation expenses and other normal
costs of making the asset serviceable for its
intended use).
Adjusted (cost) basis: The original cost basis of
the asset, adjusted by allowable increases or
decreases, used to compute depreciation
deductions.
Engineering Economy
Some definitions
Book Value (BV): The worth of a depreciable
property as shown on the accounting records
of a company. It is the original cost basis,
including any adjustments, less all allowable
depreciation deductions. It represents the
amount of capital that remains invested in the
property and must be recovered in the future
through the accounting process. It is not an
accurate measure of its market value.
Engineering Economy
Some definitions
Market Value (MV): The amount that will be paid by a
willing buyer to a willing seller for a property, where
each has equal advantage and is under no compulsion
to buy or sell.
Salvage Value (SV): The estimated value of a property
at the end of its useful life. It is the expected selling
price of a property when the asset can no longer be
used productively by its owner.
Net salvage value is used when the owner will incur
expenses in disposing of the property and these cash
outflows must be deducted from the cash inflows to obtain
a final net SV.
Engineering Economy
Some definitions
Useful life: The expected (estimated) period
that a property will be used in a trade or
business to produce income.
Recovery period: The number of years over
which the basis of a property is recovered
through the accounting process. For the
classical depreciation methods RP=Useful life.
Recovery rate: A percentage for each year of
the MACRS recovery period that is utilized to
compute an annual depreciation.
Engineering Economy
Straight line (SL):
Straight line (SL): constant amount of
depreciation each year over the depreciable
life of the asset.
N = depreciable life BVk = book value at

B = cost basis end of k
dk = depreciaton in k SVN = salvage value
Engineering Economy
Example
A laser surgical tool has a cost basis of $200,000
and a five-year depreciable life. The estimated SV
of the laser is $20,000 at the end of five years.
Determine the annual depreciation amounts
using the SL method. Tabulate the annual
depreciation amounts and the book value of the
laser at the end of each year.
Engineering Economy
Example Solution
Sample calculations for year three are as follows:
Engineering Economy
Declining-balance (DB):
Declining-balance (DB): a constant-percentage

of the remaining BV is depreciated each year.
The constant percentage is determined by R, where R = 2/N when

200% declining balance is being used, R = 1.5/N when 150%
declining balance is being used.
Engineering Economy
Example
A new electric saw for cutting small pieces of
lumber in a furniture manufacturing plant has a
cost basis of $4,000 and a 10-year depreciable
life. The estimated SV of the saw is zero at the
end of 10 years. Use the DB method to calculate
the annual depreciation amounts when
(a) R = 2/N (200% DB method)
(b) R = 1.5/N (150% DB method).
Engineering Economy
Example Solution
Sample calculations for year six are as follows:
Engineering Economy
Switch to SL from DB
Because the DB method never reaches a BV of zero, it is permissible
to switch from this method to the SL method so that an asset’s BVN
will be zero (or some other determined amount, such as SVN).
Engineering Economy
Units-of-production
The units-of-production method can be used

when the decrease in value of the asset is
mostly a function of use, instead of time. The
cost basis is allocated equally over the number
of units produced over the asset’s life. The
depreciation per unit of production is found
from the formula below.
Engineering Economy
Example
Engineering Economy
Modified Accelerated Cost Recovery System
The Modified Accelerated Cost Recovery System

(MACRS) is the principle method for computing
depreciation for property in engineering
projects. It consists of two systems, the main
system called the General Depreciation System
(GDS) and the Alternative Depreciation System
(ADS).
Engineering Economy
Modified Accelerated Cost Recovery System
When an asset is depreciated using MACRS,

the following information is needed to
calculate deductions.
Cost basis, B
Date the property was placed into service
The property class and recovery period
The MACRS depreciation method (GDS or ADS).
The time convention that applies (half year)
Engineering Economy
Using MACRS is easy!
1. Determine the asset’s recovery period

(Table 7-2).
2. Use the appropriate column from Table 7-3
that matches the recovery period to find the
recovery rate, rk, and compute the
depreciation for each year as
Engineering Economy
Comprehensive Depreciation Example
The La Salle Bus Company has decided to purchase a new bus
for $85,000 with a trade-in of their old bus. The old bus has a BV
of $10,000 at the time of the trade-in. The new bus will be kept
for 10 years before being sold. Its estimated SV at that time is
expected to be $5,000.
First, we must calculate the cost basis. The basis is the original
purchase price of the bus plus the BV of the old bus that was
traded in.Thus, the basis is $85,000 + $10,000, or $95,000.
We need to look at Table 7-2 and find buses, which are asset
class 00.23. Hence, we find that buses have a nine-year class
recovery period, over which we depreciate the bus with
historical methods, and a five-year GDS class life.
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There are many different types of taxes
Income taxes are assessed as a function of gross

revenues minus allowable expenses.
Property taxes are assessed as a function of the
value of property owned.
Sales taxes are assessed on the basis of purchase of
goods or services.
Excise taxes are federal taxes assessed as a function
of the sale of certain goods or services often
considered non-necessities.
We will focus on income taxes.
Engineering Economy
Income taxes
We should recognize that:
the income taxes paid are just another type
of expense and,
income taxes saved (through depreciation,
expenses, and direct tax credits) are identical
to other kinds of reduced expenses.
Engineering Economy
Income Taxes in Turkey
2015 Takvim yılı (G.V.K. madde:103) Gelir Vergisi Tarifesi
12.000 TL'ye kadar 15%

29.000 TL’nin 12.000 TL’si için 1.800 TL, fazlası 20%
66.000 TL’nin 29.000 TL’si için 5.200 TL (ücret gelirlerinde
27%
106.000 TL’nin 29.000 TL’si için 5.200 TL), fazlası
66.000 TL’den fazlasının 66.000 TL’si için 15.190 TL (ücret
gelirlerinde 106.000 TL’den fazlasının 106.000 TL’si için 35%
25.990 TL), fazlası
Engineering Economy

30.000 TL'nin 12.600 TL'si için 1.890 TL, fazlası 20%
69.000 TL'nin 30.000 TL'si için 5.370 TL, (ücret gelirlerinde 110.000
27%
TL'nin 30.000 TL'si için 5.370 TL), fazlası
69.000 TL'den fazlasının 69.000 TL'si için 15.900 TL, (ücret
gelirlerinde 110.000 TL'den fazlasının 110.000 TL'si için 26.970 35%
TL), fazlası
Engineering Economy

27%
TL), fazlası
2017 Takvim yılı Kurumlar Vergisi: Kurumlar vergisi, kurum kazancı üzerinden
%20 oranında alınacaktır.
Engineering Economy

27%
TL), fazlası
2018 Takvim yılı Kurumlar Vergisi: Kurumlar vergisi, kurum kazancı üzerinden
%22 oranında alınacaktır.
Engineering Economy
Taking taxes into account changes
our expectations of returns on
projects, so our MARR (after-tax) is
lower.
The after-tax MARR should be at least
the tax-adjusted weighted average cost
of capital (WACC).
 = fraction of a firm’s pool of capital borrowed

from lenders
t = effective income tax rate as a decimal
ib = before-tax interest paid on borrowed capital
ea = after-tax cost of equity capital
Depreciation is not a cash flow, but it
affects a corporation’s taxable income,
and therefore the taxes a corporation
pays.
Taxable income = gross income
– all expenses except capital invest.
– depreciation deductions.
Example
Engineering Economy
Fedaral and State Taxes (USA)
Federal taxes are calculated using a set of income
brackets, each applying a different tax rate on the
marginal value of income. State taxes vary widely.
Tax rates are found in Table 7-5.
Corporations need to know their effective tax
rate, which is a combination of federal and state
taxes according to either formula below.
Engineering Economy
The disposal of a depreciable asset can
result in a gain or loss based on the sale
price (market value) and the current
book value
A gain is often referred to as depreciation recapture,

and it is generally taxed as the same as ordinary
income. A loss is a capital loss. An asset sold for
more than it’s cost basis results in a capital gain.
Example
A corporation sold a piece of equipment during the
current tax year for $78,600. The accounting records
show that its cost basis, B, is $190,000 and the
accumulated depreciation is $139,200. Assume that
the effective income tax rate as a decimal is 0.40
(40%). Based on this information, what is
(a) the gain (loss) on disposal,

(b) the tax liability (or credit) resulting from this sale,
(c) the tax liability (or credit) if the accumulated
depreciation was $92,400 instead of $139,200?
Engineering Economy
Example Solution
(a) The BV at the time of sale is $190,000 −
$139,200 = $50,800. Therefore, the gain on
disposal is $78,600 − $50,800 = $27,800.
(b) The tax owed on this gain is −0.40($27,800) =
−$11,120.
(c) With dk = $92,400, the BV at the time of sale is
$190,000−$92,400 = $97,600.
The loss is $78,600 − $97,600 = −$19,000. The tax
credit resulting from this loss on disposal is
−0.40(−$19,000) = $7,600.
Engineering Economy
After-tax economic analysis
After-tax economic analysis is generally the

same as before-tax analysis, just using after-tax
cash flows (ATCF) instead of before-tax cash
flows (BTCF). The analysis is conducted using
the after-tax MARR.
Engineering Economy
Cash flows are typically determined for
each year using the notation below.
Rk = revenues (and savings) from the project
during period k
Ek = cash outflows during k for deductible
expenses
dk = sum of all noncash, or book, costs
during k, such as depreciation
t = effective income tax rate on ordinary
income
Tk = income tax consequence during year k
ATCFk = ATCF from the project during year k
Some important cash flow formulas
Taxable income
Ordinary income tax consequences
Engineering Economy
Example
Acme purchased a pump for $250,000 and
expended $20,000 for shipping and installation.
The addition of this pump will result in an
increase in revenue of $80,000, with associated
increased expenses of $10,000, each year. The
pump has a GDS recovery period of five years,
and Acme’s effective tax rate is 41%. What is
the ATCF for this project for the fourth year of
service of the asset?
Engineering Economy
Example
Suppose that an asset with a cost basis of $100,000 and an ADS
recovery period of five years is being depreciated under the
Alternate Depreciation System (ADS) of MACRS, as follows:
If the firm’s effective income tax rate remains constant at 40%

during this six year period, what is the PW of after-tax savings
resulting from depreciation when MARR = 10% per year (after
taxes)?
Engineering Economy
Example
The asset in the previous example is expected to
produce net cash inflows (net revenues) of
$30,000 per year during the six-year period, and
its terminal MVis negligible. If the effective
income tax rate is 40%, how much can a firm
afford to spend for this asset and still earn the
MARR? What is the meaning of any excess in
affordable amount over the $100,000 cost basis
given in the previous example?
Engineering Economy
Example Solution
After income taxes, the PW of net revenues is
(1 − 0.4)($30,000)(P/A, 10%, 6) =
$18,000(4.3553) = $78,395. After adding to this
the PW of tax savings computed in previous
example, the affordable amount is $107,343.
Because the capital investment is $100,000,
the net PW equals $7,343.
Engineering Economy
Example Solution
This same result can be obtained by using the
general format (worksheet)
Engineering Economy
Example
A highly specialized piece of equipment has a first cost of
$50,000. If this equipment is purchased, it will be used to
produce income (through rental) of $20,000 per year for only
four years. At the end of year four, the equipment will be sold for
a negligible amount. Estimated annual expenses for upkeep are
$3,000 during each of the four years. The MACRS (GDS) recovery
period for the equipment is seven years, and the firm’s effective
income tax rate is 40%.
(a) If the after-tax MARR is 7% per year, should the equipment be
purchased?
(b) Rework the problem, assuming that the equipment is placed
on standby status such that depreciation is taken over the full
MACRS recovery period.
Engineering Economy
Example Solution
Engineering Economy
Example Solution
Engineering Economy
Example
The Ajax Semiconductor Company is attempting to evaluate the
profitability of adding another integrated circuit production line to its
present operations. The company would need to purchase two or
more acres of land for $275,000 (total). The facility would cost
$60,000,000 and have no net MV at the end of five years. The facility
could be depreciated using a GDS recovery period of five years. An
increment of working capital would be required, and its estimated
amount is $10,000,000. Gross income is expected to increase by
$30,000,000 per year for five years, and operating expenses are
estimated to be $8,000,000 per year for five years. The firm’s
effective income tax rate is 40%.
(a) Set up a table and determine the ATCF for this project.
(b) Is the investment worthwhile when the after-tax MARR is 12%
per year?
Engineering Economy
Example Solution
Engineering Economy
Example Solution
The depreciable property ($60,000,000) will be disposed of for
$0 at the end of year five, and a loss on disposal of $6,912,000
will be claimed at the end of year five. Only a half-year of
depreciation ($3,456,000) can be claimed as a deduction in
year five, and the BV is $6,912,900 at the end of year five.
Because the selling price (MV) is zero, the loss on disposal
equals our BV of $6,912,000. A tax credit of 0.40($6,912,000) =
$2,764,800 is created at the end of year five. The after-tax IRR
is obtained from entries in column E and is found to be 12.5%.
The after-tax PW equals $936,715 at MARR = 12% per year.
Based on economic considerations, this integrated circuit
production line should be recommended because it appears to
be quite attractive.
Engineering Economy
Example (Unequal Lives)
A firm must decide between two system designs, S1 and S2,
whose estimated cash flows are shown in the following table.
The effective income tax rate is 40% and MACRS (GDS)
depreciation is used. Both designs have a GDS recovery period
of five years. If the after-tax desired return on investment is
10% per year, which design should be chosen?
Engineering Economy
Note that the design alternatives have different useful lives.
The same basic principles of engineering economy apply to
both before-tax and after-tax analyses. Therefore, we must
analyze the two system designs over a common period of time.
Using the repeatability assumption along with the annual
worth method simplifies the analysis of alternatives having
unequal lives.
Both alternatives would be depreciated using a five-year GDS
recovery period. No adjustments to the GDS rates are required
because the useful life of each alternative is greater than or
equal to six years of depreciation deductions.
The calculation of the ATCFs for the design alternatives is given
below:
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We can’t directly compare the PW of the after-tax cash flows
because of the difference in the lives of the alternatives. We
can, however, directly compare the AWs of the ATCFs by using
the repeatability assumption.
AWS1(10%) = PWS1(A/P, 10%, 7) = −$1,411(0.2054) = −$290
AWS2(10%) = PWS2(A/P, 10%, 6) = −$16,681(0.2296) = −$3,830
Based on an after-tax annual worth analysis, Design S1 is
preferred since it has the greater (less negative) AW. Neither
design however makes money, so if a system is not required,
don’t recommend either one.
Engineering Economy
Example: Buy vs. Lease
An engineering consulting firm can purchase a fully configured
computer aided design (CAD) workstation for $20,000. It is
estimated that the useful life of the workstation is seven years,
and its MV in seven years should be $2,000. Operating
expenses are estimated to be $40 per eight-hour workday, and
maintenance will be performed under contract for $8,000 per
year. The MACRS (GDS) property class is five years, and the
effective income tax rate is 40%.
As an alternative, sufficient computer time can be leased from
a service company at an annual cost of $20,000.
If the after-tax MARR is 10% per year, how many workdays per
year must the workstation be needed in order to justify leasing
it?
Engineering Economy
Determination of ATCF for the lease option is
relatively straightforward and is not affected by
how much the workstation is utilized:
(After-tax expense of the lease)k
=−$20,000(1−0.40)= −$12,000; for years k =1, .
. . , 7.
Engineering Economy
The after-tax annual worth (AW) of purchasing the workstation is

AW(10%) = −$20,000(A/P, 10%, 7) − $24X −[$3,200(P/F, 10%, 1) + ·· ·
+$4,800(P/F, 10%, 7)](A/P, 10%, 7) + $1,200(A/F, 10%, 7)
= −$24X − $7,511.
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Economic Value Added
Economic value added, EVA, is an estimate of

the profit-earning potential of proposed capital
investments in engineering projects. It is the
difference between a company’s adjusted net
operating profit after taxes (NOPAT) in a
particular year and its after-tax cost of capital
during that year.
Engineering Economy
where,
and
Example
For Acme, what is the EVA for year 4 if their
after-tax MARR is 8%?
Engineering Economy
Example
Consider the following proposed capital investment in an
engineering Project and determine its
(a) year-by-year ATCF,
(b) after-tax AW,
(c) annual equivalent EVA.
• Proposed capital investment = $84,000
• Salvage value (end of year four) = $0
• Annual expenses per year = $30,000
• Gross revenues per year = $70,000
• Depreciation method = Straight line
• Useful life = four years
• Effective income tax rate (t) = 50%
• After-tax MARR (i) = 12% per year
Engineering Economy
Example Solution
Engineering Economy
Example Solution
Engineering Economy

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Engineering Economy

N = depreciable life BVk = book value at

Declining-balance (DB): a constant-percentage

The constant percentage is determined by R, where R = 2/N when

The units-of-production method can be used

The Modified Accelerated Cost Recovery System

When an asset is depreciated using MACRS,

1. Determine the asset’s recovery period

Income taxes are assessed as a function of gross

We will focus on income taxes.

12.000 TL'ye kadar 15%

12.600 TL'ye kadar 15%

13.000 TL'ye kadar 15%

14.800 TL'ye kadar 15%

 = fraction of a firm’s pool of capital borrowed

A gain is often referred to as depreciation recapture,

(a) the gain (loss) on disposal,

After-tax economic analysis is generally the

Ordinary income tax consequences

If the firm’s effective income tax rate remains constant at 40%

The after-tax annual worth (AW) of purchasing the workstation is

Economic value added, EVA, is an estimate of

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