INDE/EGRM 6617-02

Engineering Economy and Cost Estimating

Chapter 7: Depreciation and Income Taxes

Dr. Alireza Namdari

[email protected]
 The objective of this chapter

After Tax Cash Flow Analysis

(ATCF)

Before Tax Cash Flow Analysis

(BTCF)

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 Depreciation is
Income taxes
an important
usually represent
element in
a significant cash
finding after-tax
outflow.
cash flows.

Economic
Income
Depreciation Decision
Taxes
Making

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 Depreciation
Definition:
• It is the decrease in value of physical properties with
the passage of time.

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.

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 Depreciable property:
• It is property for which depreciation is allowed under
federal, state, or municipal tax laws and regulations.

a) Tangible: It can be seen or touched.

• Personal: machinery, vehicles, equipment, furniture, …
• Real: land or anything attached to land

b) Intangible: It is not visible.

• Such as copyrights, patents, or franchises
as long as the
depreciable
property is in
Depreciation: service
✓ starts when the property is ready for use.
✓ stops when the property is sold.

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The Classical (Historical) Depreciation Methods

1. Straight-Line (SL) Method:

Constant amount of depreciation each year over the
depreciable life of the asset

N = depreciable life BVk = book value at end of k

B = cost basis SVN = salvage value
dk = depreciaton in k
dk ∗ = cumulative depreciation through year k
k

(Book Value)k = Cost Basis − ෍(Depreciation Deduction)j

j=1
BVk = B – dk ∗ 6
 Example

An asset is purchased that costs $12,000. It has an 8-year

life and a salvage value of $2,000.

a) Tabulate the annual depreciation amounts and book

value of the asset at the end of each year.
b) Find the straight-line depreciation in year 5 and the
cumulative deduction through year 7.
c) What is the book value of the asset after 4 years?

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2. Declining-Balance (DB) Method:
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.
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 Example

A new mechanical equipment for manufacture of motor

vehicles has a cost basis of $25,000 and a 5-year
depreciable life. The estimated salvage value of the asset is
negligible.
Use a %150 DB and calculate the annual depreciation
amounts and book values.

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3. DB with Switchover to SL:

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.

The switchover occurs the year in which an equal or

a larger depreciation amount is obtained from the SL
method.

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 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 salvage value
of the saw is zero at the end of 10 years. Use 200% DB
with Switchover to SL to calculate the annual depreciation
amounts.

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𝐵𝑉10 is $4,000 − $3,570.50 = $429.50 without switchover to the SL method.

With switchover, 𝐵𝑉10 equals zero.

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 The Modified Accelerated Cost Recovery
System (MACRS)
The Modified Accelerated Cost Recovery System
(MACRS) is the principal 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).

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When an asset is depreciated using MACRS, the
following information is needed to calculate deductions:

1. Cost basis, B
2. Date the property was placed into service
3. The property class and recovery period
4. The MACRS depreciation method (GDS or ADS).
5. The time convention that applies (half year)

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 Using MACRS is easy!

Step 1: Determine the asset’s recovery period (Table 7-2).

Step 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

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 Study Period < MACRS Recovery Period

A half-year convention is used in MACRS depreciation

calculations for tangible personal property. This means
that all assets placed in service during the year are
treated as if use began in the middle of the year. And
one-half year of depreciation is allowed.
When an asset is disposed of, the half-year convention is
also allowed. If the asset is disposed of before the full
recovery period is used, then only half of the normal
depreciation deduction can be taken for that year.

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Figure 7-1 Flow Diagram for computing Depreciation
Deductions under MACRS

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 Example

A firm purchased and placed in service an office furniture.

The cost basis for the asset is 20,000.
Calculate the annual depreciation and book value for this
asset from year 1 to year 6 using GDS.

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 Example 7-7
A 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.

Compute the depreciation amounts and book value of the

asset at the end of each year using:
a) the straight-line method
b) the 200% declining balance method
c) the MACRS method.
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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 nonnecessities.
❖ We will focus on income taxes.
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Taking taxes into account changes our
expectations of returns on projects, so our
MARR (after-tax) is lower.

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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

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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.

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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.

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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.
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 Example
Acme Casting and Molding sold a piece of equipment
during the current tax year for $67,000. This equipment had
a cost basis of $210,000 and the accumulated depreciation
was $153,000. Assume the effective income tax rate is 40%.
Based on this information, what is

a) The gain (loss) on disposal

b) The tax liability (or credit) resulting from this sale, and
c) The tax liability (or credit) if the accumulated
depreciation was $125,000 instead of $153,000

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 Solution
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 $125,000 instead of $153,000

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After Tax Cash Flow Analysis (ATFC)

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.

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• 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

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Some important cash flow formulas:

Taxable income

Ordinary income tax consequences

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Figure 7-5 General Format (Worksheet) for After-Tax
Analysis; Determining the ATCF

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 Example 7-20
A firm must decide between two system designs, S1and 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?

Design
S1 S2
Capital investment $100,000 $200,000
Useful life (years) 7 6
MV at end of useful life $30,000 $60,000
Annual revenues less expenses $20,000 $40,000
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 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) annual worth. Neither designs however
makes money, so if a system is not required, don’t recommend either one.
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 Example
Suppose that an asset with a cost basis of $30,000 is depreciated
under Alternative Depreciation System (ADS) of MACRS with an
ADS recovery period of five years. During the 6-year useful life, it is
estimated the firm will produce net cash flows of $9,000 per year.
The salvage value of this asset is estimated to be negligible.

Q1: Develop the ATCF. (Effective Income Tax Rate: t = 0.38)

Q2: Use the PW and IRR methods to determine whether the project
(after income taxes have been paid) is economically justified. (After-
tax MARR = 10%)

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 Example
A company would like to purchase a new automobile for use. The
equipment costs $25,000. During the equipment’s 4-year
useful/depreciable life, it is estimated the firm will save $8,500 per
year after all the costs of owning and operating the equipment have
been paid. The salvage value of this equipment is estimated to be
$4,200. Assuming that GDS is used for the equipment:

Q1: Develop the ATCF. (Effective Income Tax Rate: t = 0.35)

Q2: Use the PW and IRR methods to determine whether the project
(after income taxes have been paid) is economically justified. (After-
tax MARR = 12%)

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