ENGINEERING AND PROJECT

MANAGEMENT
MMB 533

LECTURER:
Dr L. Seboni
OFFICE: 247/475
[email protected]

HAND OUT - Cost of Capital, Depreciation and Income Tax

 Cost of Capital, Depreciation and
Income
 Asset Depreciation:
Tax
 Depreciation can be defined as the gradual decrease in utility of
fixed assets with use and time.

 Fixed assets are economic resources such as equipment and real

estate which are obtained to provide future cash flows.

 Depreciation can be classified into categories (see notes below)

as shown in the diagram below:

1. Physical depreciation, part of economic depreciation is a

general reduction in an asset’s capacity to perform; occurs due
to:
i. Deterioration due to interaction with environment, e.g. corrosion,
rotting, etc.
ii. Wear and tear from use.
 Cost of Capital, Depreciation and
Income Tax
 Figure 10.1 Classification of Depreciation:
 Cost of Capital, Depreciation and
Income Tax
2. Functional depreciation part of economic depreciation occurs
due to:
i. Technological obsolesce.
ii. Reduction in the need of certain services performed by an
asset, etc.

 Physical and functional depreciation are categories of economic

depreciation which form the basis of understanding Accounting
Depreciation.

1. Economic depreciation = Purchase Price – Market Value

2. Accounting depreciation defined as the systematic allocation

of the initial cost of an asset in parts over a certain time,
known as its depreciable life takes out the need to have a
precise scheme for recording the ongoing decline in the value
of an asset in order to get its economic worth.
 Cost of Capital, Depreciation and
Income Tax
 Accounting depreciation also known as asset depreciation uses
the matching concept, which attempts to match the cost of the
reduction in the economic worth of an asset over the duration of
its depreciable life.

 Asset Depreciation (Accounting Depreciation) Concepts:

 To calculate depreciation we need to know certain information

such as:
1. What is the cost of the asset?
2. What is the asset’s value at the end of its useful life?
3. What is the depreciable life of the asset?
4. What method of depreciation do we choose?
 Cost of Capital, Depreciation and
Income Tax
 Depreciable property; which assets can depreciation be claimed
against revenues as expenses to the business?

1. It must be used in business or held for the production of

income.
2. It must have a definite service life, which must be longer than
one year.
3. It must be something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.

 Examples of these are; buildings, machinery, equipment,

vehicles, and some intangible properties. Inventories are not
depreciated because they are for sale, and land is not as well
because its service life is infinite.
 Cost of Capital, Depreciation and
Income Tax
 Cost Basis of an asset represents the total cost that is claimed
as an expense over an asset’s life (i.e., the sum of the annual
depreciation expenses). It includes the actual cost of an asset
and all other incidental expenses, such as freight, site
preparation, and installation. This total cost, rather than the
cost of the asset only, must be depreciated.
 Cost of Capital, Depreciation and
Income Tax
 If the asset is purchased by trading in a similar asset, the
difference between the book value ( which is cost basis minus
the total accumulated depreciation) and trade-in allowance (see
notes below) must be considered in determining the cost basis
for the new asset.

 If the trade-in allowance exceeds the book value, the difference

(known as unrecognized gain) needs to be subtracted from the
cost basis of the new asset.

 If the opposite is true (unrecognized loss), it should be added to

the cost basis for the new asset.

 Exercise 2: Cost Basis with Trade-In Allowance: In the example

above, suppose Lanier purchased the hole-punching press by
trading in a similar machine and paying cash for the remainder
 Cost of Capital, Depreciation and
Income Tax
 The trade-in allowance is $5 000 and the book value of the hole-
punching machine that was traded in is $4 000. Determine the
cost basis for this hole-punching press.

 Useful Life and Salvage Value refers to how many periods will
an asset be useful to the company and salvage value of an asset
is the estimated value at the end of its life (see notes below).

 Historically useful life was tied to service life of an asset, but

service life was very difficult and got abandoned because of
disagreements between tax collector and tax payer.

 A new scheme called Asset Depreciation Ranges, (ADRs) was

adopted, which gave guidelines to how specific assets can be
depreciated in terms of range of years.
 Cost of Capital, Depreciation and
Income Tax
 Depreciation Methods: Book and Tax Depreciation:

 Book depreciation is used for financial reports (balance sheet and

income statement) while Tax depreciation is used for tax purposes.

 Reasons for using two methods to estimate depreciation differently

are as follows:

1. Book depreciation enables firms to report depreciation to

stockholders and other significant outsiders based on the
matching concept. Therefore the actual loss in value of the asset is
generally reflected.

2. Tax depreciation allows firms to benefit from the tax advantages

of depreciating assets more quickly than would be possible using
the matching concept. More depreciation at the beginning of the
capitalized equipment and less at later years but overall
depreciation is equal in both cases.
 Cost of Capital, Depreciation and
Income Tax
 Book Depreciation Methods: Three [3] methods can be used
for book depreciation and these are:

1. Straight-Line Method:

 The method of depreciation interprets a fixed asset as an asset

that provides its services in a uniform fashion. The asset
provides an equal amount of service in each year of its useful
life.

 The straight-line method charges, as an expense, an equal

fraction of the net cost of the asset each year, as expressed by
the formula below:
 Cost of Capital, Depreciation and
Income Tax
(𝐼 −𝑆)
 Dn =
𝑁

 Where: Dn = Depreciation charge during year n

 I = Cost of the asset including installation expenses
 S = Salvage value at the end of the useful life
 N = Useful life

 The book value of the asset at the end of n years is then given as:

 Book value in a given year = Cost basis – total depreciation

charges made to date

 Bn = I – (D1 + D2 + D3 +…….+ Dn)

 Cost of Capital, Depreciation and
Income Tax
2. Accelerated Methods:

 The second concept in depreciation recognizes that the stream

of services provided by a fixed asset may decrease over time; in
other words, the stream may be greatest in the first year of an
asset’s service life and least in its last year. Some of the possible
reasons for this are as below:

 Mechanical efficiency of an asset tends to decline with age.

 Cost of Capital, Depreciation and
Income Tax
 Maintenance costs tends to increase also with age.
 Technological changes with better equipment becoming available

 Hence the idea is to depreciate faster at early years than in later

years. Two methods can be used here:

 1. Declining Balance Method (DB):

 This method of calculating depreciation allocates a fixed fraction

of the beginning book balance each year. The fraction α is
obtained as follows:

1
 α = ( )(multiplier)
𝑁
 Cost of Capital, Depreciation and
Income Tax
 Common multipliers are 1.5 (called 150% DB) and 2.0 (called
200%, or Double DB). As N increases 𝜶 decreases resulting in
large depreciation expenses in the first years.

 Depreciation charges after obtaining 𝛼 can be obtained for a

given year as below:

 D1 = αI
 D2 = α(I – D1) = αI(1 – α)
 D3 = α(I – D1 – D2) = αI(1 – α)2,

 and thus for any year, n, we have a depreciation charge, Dn, of:

 Dn = αI(1 – α)n – 1
 Cost of Capital, Depreciation and
Income Tax
 We can also compute the total DB depreciation (TDB) at the end
of n years as follows:

 TDB = D1 + D2 +…. Dn

 = αI + αI(1 – α) + αI(1 –α)2 +…..+ αI(1 – α)n - 1

 = αI[1 + (1 – α) + (1 – α)2 +……..+(1 – α)n – 1]

 TDB = I[1 – (1 – α)n]

 Cost of Capital, Depreciation and
Income Tax
 The book value, Bn, at the end of n years will be the cost of the
asset I, minus the total depreciation at the end of N years:

 Bn = I – TDB
 = I – I[1 – (1 – α)n]
 Bn =I(1 – α)n
 Cost of Capital, Depreciation and
Income Tax
 Case 2 BN > 𝑺: When BN > S, we are faced with a situation in
which we have not depreciated the entire cost of the asset and
thus not taken full advantage of depreciation’s tax deferring
benefits.

 If you would prefer to reduce the book value of an asset to its

salvage value as quickly as possible, it can be done by switching
from DB to SL whenever SL depreciation results in larger
depreciation charges and therefore a more rapid reduction in
the book value of the asset.

 The switch from DB to SL depreciation can take place in any of

the n years, the objective being to identify the optimal year to
switch.
 Cost of Capital, Depreciation and
Income Tax
 The switching rule is as follows: If depreciation by DB in any year
is less than (or equal to) what it would be by SL; we should
switch to and remain with the SL method for the duration of the
project’s depreciable life.

 Then the straight-line depreciation in any year would be given as

below:

Book value at beginning of year 𝑛 −salavage value

 Dn =
Remaining useful life at beginning of year 𝑛
 Cost of Capital, Depreciation and
Income Tax
 Cost basis of the asset, I = $10 000
 Useful life, N = 5 years
 Salvage value, S = $0
 α = (1/5)(2) = 40%

 Case 3: BN < 𝑺: Salvage value (S) must be estimated at the outset

of depreciation analysis. According to tax law salvage value
should not be greater than book value, when this occurs we
readjust our calculations so that BN = S.
 Cost of Capital, Depreciation and
Income Tax
 2. Sum-of-Years’-Digits (SOYD) Method:

 Another accelerated method for allocating the cost of an asset is

called sum-of-years’ digits (SOYD) depreciation.

 In the SOYD method, the numbers 1, 2, 3,….., N are summed,

where N is the estimated years of useful life. We find this sum by
the equation:

𝑁(𝑁+1)
 SOYD = 1 + 2 + 3 +……+ N =
2

 Then the depreciation rate for each year is given by the below
formula:
 Cost of Capital, Depreciation and
Income Tax
𝑁−𝑛+1
 Dn = (I – S)
𝑆𝑂𝑌𝐷

 Exercise 7: SOYD Depreciation: Compute the SOYD depreciation

schedule given the following information; Cost basis, I = $10 000,
Useful life, N = 5 years, and Salvage Value, S = $2 000. (see notes
below).

3. Units-of-Production Method:

 This method takes into consideration that an asset may be used

to generate different number of units each year, resulting in
difference of depreciation as per number/output produced per
year.

 Since the cost of each service unit is the net cost of the asset
divided by the total number of such units, the depreciation
 Cost of Capital, Depreciation and
Income Tax
 formula can be shown as below:

Service units consumed during year 𝑛

 Dn = (I – S)
Total service units

 An advantage of the method is that depreciation varies with

production volume, and therefore the method gives a more
accurate picture of machine usage.

 A disadvantage of the method is that the collecting of data on

machine use and the accounting methods are somewhat
tedious.
 Cost of Capital, Depreciation and
Income Tax
 Tax Depreciation Method:

 This method replaced the historically used book depreciation

methods for purposes of calculating tax.

 The MARCS (Modified Accelerated Cost Recovery System)

created simple guidelines to show allowable recovery periods.

 These recovery periods do not necessarily bear any relationship

to expected useful lives. And under tax depreciation salvage
value of property is always treated as zero.

 A MARCS property classification shown below shows which

properties fall under which classification:
 Cost of Capital, Depreciation and
Income Tax

Adapted from Park, C, S (2002, pp. 467)

*ADR = Asset Depreciation Range: Guidelines are published by the IRS.
ϯAutomobiles have a midpoint life of 3 years in the ADR Guidelines, but are classified into a 5 year property class.
 Cost of Capital, Depreciation and
Income Tax
 Tax depreciation method uses DB switching over to SL, it also
uses the concept of half year convention, table below shows
MARCS depreciation schedules.

 Half year means half of depreciation is taken on the first year of

depreciation and on the last year following recovery period. This
is because an assumption is made that an asset is placed in use
at mid year.

 Mid-Month Convention for Real Property this method of

depreciating real property uses the mid-month and SL method
as for computing the depreciation schedule [See handout].
 Cost of Capital, Depreciation and Income Tax
 MARCS Depreciation Schedules with Half Year Convention: