Engineering Economics

Lesson 4
Decisions Under Certainty
 Engineering Economics
Lecture 4.1
Depreciation
Sullivan, et al. (2015). Engineering Economy, 16th ed., Chapter 7 (pp. 308-367)
Objective
Objective:
To explain how
depreciation
affects income
taxes and how
income taxes
affect economic
decision making
Depreciation Concepts and Terminologies

• Depreciation is a noncash cost that is intended to “match” the yearly

fraction of value used by an asset in the production of income over the
asset’s life.
• The actual amount of depreciation can never be established until the asset
is retired from service.
• Because depreciation is a noncash cost that affects income taxes, we must
consider it properly when making after-tax engineering economy studies.
Depreciation Concepts and Terminologies

Depreciable Property
• Depreciable property is property for which depreciation is allowed
under federal, state, or municipal income tax laws and regulations.
• To determine whether depreciation deductions can be taken, the
classification of various types of property must be understood.
• In general, property is depreciable if it meets several basic
requirements.
Depreciation Concepts and Terminologies

Requirements for a Depreciable Property:

1. It must be used in business or held to produce income.
2. It must have a determinable useful life, and the life 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.
4. It is not inventory, stock in trade, or investment property.
Depreciation Concepts and Terminologies

Classifications of Depreciable Property:

Tangible Intangible

can be seen or touched cannot be seen or touched

2 main types:
• Personal property – assets such as machinery,
vehicles, equipment, furniture, etc. personal property such as copyright,
• Real property – land* and generally anything that patent, or franchise
is erected on, growing on, or attached to land

*Land itself is not depreciable, because it does not have a determinable life
Depreciation Concepts and Terminologies

Property in Service
• A company can begin to depreciate property it owns when the
property is placed in service for use in the business and for the
production of income.
• Property is considered to be placed in service when it is ready and
available for a specific use, even if it is not actually used yet.
• Depreciation stops when (1) the cost of placing an asset in service has
been recovered, or (2) when the asset is sold, whichever occurs first.
Depreciation Concepts and Terminologies

Additional Definitions

Adjusted Basis / Cost Market

Book Value
(Cost) Basis Basis Value

Recovery Recovery Salvage

Useful Life
Period Rate Value
Depreciation Concepts and Terminologies

Adjusted (Cost) Basis

• The original cost basis of the asset, adjusted by allowable increases or
decreases, is used to compute depreciation deductions.
• Ex. The cost of any improvement to a capital asset with a useful life
greater than one year increases the original cost basis, and a casualty
or theft loss decreases it.
• If the basis is altered, the depreciation deduction may need to be
adjusted.
Depreciation Concepts and Terminologies

Basis or Cost Basis

• The initial cost of acquiring an asset (purchase price plus any sales
taxes), including transportation expenses and other normal costs of
making the asset serviceable for its intended use;
• this amount is also called the unadjusted cost basis.
Book Value (BV)
• The worth of a depreciable property as shown on the accounting records
of a company.
• It is the original cost basis of the property, 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.
• The BV of a property may not be an accurate measure of its market value.
• In general, the BV of a property at the end of year 𝑘 is
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.
• The MV approximates the present value of what will be received
through ownership of the property, including the time value of money
(or profit).
Recovery Period
• The number of years over which the basis of a property is recovered
through the accounting process.
• For the classical methods of depreciation, this period is normally the
useful life.
• Under the Modified Accelerated Cost Recovery System (MACRS), this
period is the property class for the General Depreciation System
(GDS), and it is the class life for the Alternative Depreciation System
(ADS).
Recovery Rate
• A percentage (expressed in decimal form) for each year of the MACRS
recovery period that is utilized to compute an annual depreciation
deduction.
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.
• The term 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.
• Under MACRS, the SV of a depreciable property is defined to be zero.
Useful Life
• The expected (estimated) period that a property will be used in a
trade or business to produce income.
• It is not how long the property will last but how long the owner
expects to productively use it.
Depreciation Methods

Classical • Straight Line (SL) Method

(Historical) • Declining Balance (DB) Method
Depreciation • DB with switch to SL
Methods • Units-of-production Method
Modified
Accelerated • General Depreciation System (GDS)
Cost Recovery
System • Alternative Depreciation System (ADS)
(MACRS)
Classical (Historical) Depreciation Methods:

Straight Line (SL) Method

• The simplest depreciation method; assumes that a constant amount is
depreciated each year over the depreciable (useful) life of the asset.
• If we define:

Note: For this method, you

must have an estimate of
the final SV, which will
also be the final BV at the
end of year N. In some
cases, the estimated SVN
may not equal an asset’s
actual terminal MV.
Classical (Historical) Depreciation Methods:

• Cont..
Classical (Historical) Depreciation Methods:

Solution (cont..)
Classical (Historical) Depreciation Methods:

Declining Balance (DB) Method

• Sometimes called the constant-percentage method or the Matheson
formula, it is assumed that the annual cost of depreciation is a fixed
percentage of the BV at the beginning of the year.
• The ratio of the depreciation in any one year to the BV at the
beginning of the year is constant throughout the life of the asset and
is designated by 𝑅 (0 ≤ 𝑅 ≤ 1).
2
• In this method, 𝑅 = when a 200% DB is being used (i.e., twice the
𝑁
SL rate of 1/𝑁), and 𝑁 equals the depreciable (useful) life of an asset.
1.5
• If the 150% DB method is specified, then 𝑅 = .
𝑁
Classical (Historical) Depreciation Methods:

Declining Balance (DB) Method

• The following relationships hold true for the DB method:

• Notice that Equations (7-5) through (7-8) do not contain a term for
SVN.
Classical (Historical) Depreciation Methods:
Classical (Historical) Depreciation Methods:
Classical (Historical) Depreciation Methods:
Classical (Historical) Depreciation Methods:

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 (or some other determined amount, such as SVN).
• Also, this method is used in calculating the MACRS recovery rates.
• Table 7-1 illustrates a switchover from double DB depreciation to SL
depreciation for Example 7-2.
• The switchover occurs in the year in which an equal or a larger
depreciation amount is obtained from the SL method.
Classical (Historical) Depreciation Methods:
• From Table 7-1, it is apparent
that 𝑑6 = $262.14.
• The BV at the end of year six
(𝐵𝑉6 ) is $1,048.58.
• Additionally, observe that
𝐵𝑉10 is $4,000−$3,570.50 =
$429.50 without switchover to
the SL method.
• With switchover, 𝐵𝑉10 = 0.
• It is clear that this asset’s 𝑑𝑘 ,
𝑑𝑘∗ , and 𝐵𝑉𝑘 in years 7 through
10 are established from the SL
method, which permits the full
cost basis to be depreciated
over the 10-year recovery
period.
Classical (Historical) Depreciation Methods:

Units-of-production Method
• All the depreciation methods discussed to this point are based on
elapsed time (years) on the theory that the decrease in value of
property is mainly a function of time.
• When the decrease in value is mostly a function of use, depreciation
may be based on a method not expressed in terms of years.
• The units-of-production method is normally used in this case.
• This method results in the cost basis (minus final SV) being allocated
equally over the estimated number of units produced during the
useful life of the asset.
• The depreciation rate is calculated as
Classical (Historical) Depreciation Methods:
The Modified Accelerated Cost Recovery
System (MACRS)
• The MACRS was created by Tax Reform Act of 1986 (TRA 86) and is now the
principal method for computing depreciation deductions for property in
engineering projects.
• MACRS applies to most tangible depreciable property placed in service
after December 31, 1986.
• Examples of assets that cannot be depreciated under MACRS are property
you elect to exclude because it is to be depreciated under a method that is
not based on a term of years (units-of-production method) and intangible
property.
• Previous depreciation methods have required estimates of useful life (N)
and SV at the end of useful life (SVN).
• Under MACRS, however, SVN is defined to be zero, and useful life estimates
are not used directly in calculating depreciation amounts.
Modified Accelerated Cost Recovery System (MACRS):

• In general, ADS provides a longer recovery period and uses only the
SL method of depreciation.
• Property that is placed in any tax-exempt use and property used
predominantly outside the United States are examples of assets that
must be depreciated under ADS.
• Any property that qualifies under GDS, however, can be depreciated
under ADS, if elected.
Modified Accelerated Cost Recovery System (MACRS):
When an asset is depreciated under MACRS, the following
information is needed before depreciation deductions can be
calculated:
1. The cost basis (B)
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation method to be used (GDS or ADS)
5. The time convention that applies (half year)
Modified Accelerated Cost Recovery System (MACRS):

Property Class and Recovery Period

• Under MACRS, tangible depreciable property is categorized (organized) into
asset classes.
• The property in each asset class is then assigned a class life, GDS recovery
period (and property class), and ADS recovery period.
• For our use, a partial listing of depreciable assets used in business is
provided in Table 7-2.
• The types of depreciable property grouped together are identified in the
second column.
• Then the class life, GDS recovery period (and property class), and ADS
recovery period (all in years) for these assets are listed in the remaining
three columns.
Modified Accelerated Cost Recovery System (MACRS):

Under the GDS, the basic information about property classes

and recovery periods is as follows:
1. Most tangible personal property is assigned to one of six personal
property classes (3-, 5-, 7-, 10-, 15-, and 20-year property). The
personal property class (in years) is the same as the GDS recovery
period. Any depreciable personal property that does not “fit” into
one of the defined asset classes is depreciated as being in the
seven-year property class.
2. Real property is assigned to two real property classes:
nonresidential real property and residential rental property.
3. The GDS recovery period is 39 years for nonresidential real property
(31.5 years if placed in service beforeMay13, 1993) and 27.5 years
for residential real property.
Modified Accelerated Cost Recovery System (MACRS):

The following is a summary of basic

information for the ADS:
1. For tangible personal property, the ADS recovery period is shown in
the last column on the right of Table 7-2 (and is normally the same
as the class life of the property; there are exceptions such as those
shown in asset classes 00.12 and 00.22).
2. Any tangible personal property that does not fit into one of the
asset classes is depreciated under a 12-year ADS recovery period.
3. The ADS recovery period for nonresidential real property is 40
years.
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
The primary methods used under MACRS for calculating the depreciation
deductions over the recovery period of an asset are summarized as follows:
1. GDS 3-, 5-, 7-, and 10-year personal property classes: The 200% DB
method, which switches to the SL method when that method provides a
greater deduction. The DB method with switchover to SL was illustrated
in Section 7.3.3.
2. GDS 15- and 20-year personal property classes: The 150% DB method,
which switches to the SL method when that method provides a greater
deduction.
3. GDS nonresidential real and residential rental property classes: The SL
method over the fixed GDS recovery periods.
4. ADS: The SL method for both personal and real property over the fixed
ADS recovery periods.
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• A half-year time 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.
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• The GDS recovery rates (𝑟𝑘 ) for the six personal property classes that
we will use in our depreciation calculations are listed in Table 7-3.
• The GDS personal property rates in Table 7-3 include the half-year
convention, as well as switchover from the DB method to the SL
method when that method provides a greater deduction.
• Note that, if an asset is disposed of in year N, the final BV of the asset
will be zero.
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• The depreciation deduction (𝑑𝑘 ) for an asset under MACRS (GDS) is
computed with
Modified Accelerated Cost Recovery System (MACRS):
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• The information in Table 7-4 provides a summary of the principal
features of GDS under MACRS.
• Included are some selected special rules about depreciable assets.
• A flow diagram for computing depreciation deductions under MACRS
is shown in Figure 7-1.
• As indicated in the figure, an important choice is whether the main
GDS is to be used for an asset or whether ADS is elected instead (or
required).
• Normally, the choice would be to use the GDS for calculating the
depreciation deductions.
Modified Accelerated Cost Recovery System (MACRS):
Modified Accelerated Cost Recovery System (MACRS):

Solution:
Modified Accelerated Cost Recovery System (MACRS):
Modified Accelerated Cost Recovery System (MACRS):
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• From Example 7-5, we can conclude that Equation 7-11 is true from the
buyer’s viewpoint when property of the same type and class is exchanged:

• To illustrate Equation (7-11), suppose your company has operated an

optical character recognition (OCR) scanner for two years.
• Its BV now is $35,000, and its fair MV is $45,000.
• The company is considering a new OCR scanner that costs $105,000.
• Ordinarily, you would trade the old scanner for the new one and pay the
dealer $60,000.
• The basis (B) for depreciation is then $60,000 + $35,000 = $95,000.∗
Modified Accelerated Cost Recovery System (MACRS):

Depreciation Methods, Time Convention,

and Recovery Rates
• The information in Table 7-4 provides a summary of the principal
features of GDS under MACRS.
• Included are some selected special rules about depreciable assets.
• A flow diagram for computing depreciation deductions under MACRS
is shown in Figure 7-1.
• As indicated in the figure, an important choice is whether the main
GDS is to be used for an asset or whether ADS is elected instead (or
required).
• Normally, the choice would be to use the GDS for calculating the
depreciation deductions.
A Comprehensive Depreciation Example
• We now consider an asset for which depreciation is computed by the
historical and MACRS (GDS) methods previously discussed.
• Be careful to observe the differences in the mechanics of each
method, as well as the differences in the annual depreciation
amounts themselves.
• Also, we compare the present worths (PWs) at 𝑘 = 0 of selected
depreciation methods when MARR=10% per year.
• Depreciation methods that result in larger PWs (of the depreciation
amounts) are preferred by a firm that wants to reduce the present
worth of its income taxes paid to the government.
Solution (cont..)
end