engineering economy

Decisions under uncertainty:Depreciation and after-tax economic analysis : 

Decisions under uncertainty:Depreciation and after-tax economic analysis

Depreciation methods : 

Depreciation methods

Introduction : 

Introduction Depreciation is a bothersome fact that must be dealt with in business and economy studies. It is the decrease in value of physical properties with the passage of time. Although the fact that depreciation does occur is easily ascertained and recognized, the determination of its magnitude in advance, as must be done in economy studies, is not easy.

Slide 4: 

In fact, the actual amount of depreciation can never be determined until the asset is retired from service. But because depreciation is a cost and thus must be considered properly in economy studies, it is clear that the analyst encounters some problems in dealing with it. At the same time, it is equally evident that the cost of depreciation, as contained in an economy study, will be an estimate, and it most likely will not be entirely accurate.

Slide 5: 

Why is depreciation important to engineering economy? Depreciation is a tax-allowed deduction included in tax calculations in virtually all industrialized countries. Depreciation lowers income taxes via the relation Taxes = (income – deductions)(tax rate) Income taxes (UNYA NA!!!)

Slide 6: 

Purposes of Depreciation To provide for the recovery of capital that has been invested in physical property To enable the cost of depreciation to be charged to the cost of producing products or services that result from the use of the property. Depreciation cost is real, as are labor and material costs, and it is deductible in computing profits on which income taxes are paid

Depreciation terms : 

Depreciation terms Depreciation – is the reduction in value of an asset. Book depreciation – term use by a corporation or business for internal financial accounting. Tax depreciation – term us in tax calculations per government regulations. First cost – is the delivered and installed cost of the asset including purchase price, delivery and installation fees, and other depreciable direct costs incurred to prepare the asset for use.

Slide 8: 

Book value – represents the remaining, undepreciated capital investment on the books after the total amount of depreciation charges to date have been subtracted from the basis. (Bn = Bn-1 – Dn) Recovery period – is the depreciable life n of the asset in years. Market value – a term also used in replacement analysis, is the estimated amount realizable if the asset were sold on the open market

Slide 9: 

Salvage value – is the estimated trade-in market value at the end of the asset’s useful life. Depreciation rate – is the fraction of the first cost removed by depreciation each year. Personal property – one of the two types of property for which depreciation is allowed, is the income-producing, tangible possessions of a corporation used to conduct business. Real property – office buildings, manufacturing structures, and other structures. Also land but it’s not depreciable.

Slide 10: 

Half-year convention – assumes that assets are placed in service or disposed of in midyear, regardless of when these events actually occur during the year.

Straight-line (sl) : 

Straight-line (sl) It writes off capital investment linearly over n years. The estimated salvage value is always considered. This is the classical, nonaccelerated depreciation model. Formula: L = useful life of the structure in years, C = the original cost, d = the annual cost of depreciation, Cn = the book value at the end of n years,

Slide 12: 

CL = the value at the end of the life of the structure, the scrap value (including gain or loss due to removal), and Dn = depreciation up to age n years;

Declining balance (DB) : 

Declining balance (DB) The model accelerates depreciation compared to straight line. The book value is reduced each year by a fixed percentage. The most used rate is twice the SL rate, which is called double declining balance (DDB). k = 2/L It has an implied salvage that may be lower than the estimated salvage. It is not an approved tax depreciation method in the United States. It is frequently used for book depreciation purposes.

Slide 14: 

Formula: Depreciation during the first year: d1 = C x k Depreciation during the nth year: dn = (Cn-1)k Slavage Value at age L years: CL = C(1-k)L Book value at age n years: Rate of Depreciation:

Modified accelerated cost recovery System (MACRS) : 

Modified accelerated cost recovery System (MACRS) It is the only approved tax depreciation system in the United States. It automatically switches from DDB or DB to SL depreciation. It always depreciates to zero; that is, it assumes S = 0. Recovery periods are specified by property classes. Depreciation rates are tabulated.

Slide 16: 

The actual recovery period is 1 year longer due to the imposed half-year convention. MACRS straight line depreciation is an option, but recovery periods are longer than for regular MACRS.

Depletion Methods : 

Depletion Methods Cost depletion – sometimes referred to as factor depletion, is based on the level of activity or usage, not time, as in depreciation. It may be applied to most types of natural resources. Pt = first cost / resource capacity

Slide 18: 

Percentage depletion – is a special consideration given for natural resources. A constant, stated percentage of the resource’s gross income may be depleted each year provided it does not exceed 50% of the company’s taxable income. Percentage depletion amount = percentage x gross income from property

After-Tax Economic Analysis : 

After-Tax Economic Analysis

Terminology and rates : 

Terminology and rates Gross income (GI) – is the total income realized from all revenue-producing sources of the corporation, plus anyu income from other sources such as sale of assets, royalties, and license fees. Income tax – is the amount of taxes based on some form of income or profit that must be delivered to a federal (or lower-level) government agency

Slide 24: 

Operating expense E – include all corporate costs incurred in the transaction of business. Taxable income (TI) – is the amount upon which taxes are based. TI = GI – E – D Tax rate (T) – is apercentage, or decimal equivalent, of TI owed in taxes. The general formula for tax computation. Taxes = (TI)(T) Net profit after taxes (NPAT) – is the amount remaining each year when income taxes are subtracted from taxable income.

Slide 25: 

NPAT = TI – (TI)(T) = (TI)(1 - T) Before-tax – initial profit or income gained before deducting tax. Average tax rate = taxes / TI Effective tax rate, Te = state rate + (1 – state rate)(federal rate) Taxes = (TI)(Te)

CFBT (Cash Flow Before Taxes) and CFAT (Cash Flow After Taxes) : 

CFBT (Cash Flow Before Taxes) and CFAT (Cash Flow After Taxes) CFBT = gross income – expense – initial investment + salvage value = GI – E – P + S CFAT = CFBT – taxes where taxes are estimated using the relation (TI)(T) or (TI)(Te)

Depreciation recapture and capital gains : 

Depreciation recapture and capital gains Capital gain (CG) – is an amount incurred when the selling price exceeds its first cost Capital gain = selling price – first cost CG = SP – P Depreciation recapture (DR) – occurs when a depreciable asset is sold for more than the current book value BVt. Depreciation recapture = selling price – book value DR = SP - BVt

Slide 29: 

Capital loss (CL) – occurs when a depreciable asset is disposed of for less than its current book value. Capital loss = book value – selling price CL = BV – SP TI = gross income – expenses – depreciation + depreciation recapture + capital gain – capital loss = GI – E – D + DR + CG – CL

After-tax Analysis : 

After-tax Analysis The required after-tax MARR is established using the market interest rate, the corporation’s effective tax rate, and its average cost of capital. The CFAT estimates are used to compute the PW or AW at the after-tax MARR. When positive and negative CFAT values are present, the result of PW or AW < 0 indicates the MARR is not met.

Slide 31: 

For mutually exclusive alternative comparison, use the guidelines below to select the better alternative. If alternative PW or AW ? 0, the required after-tax MARR is met or exceeded; the alternative is financially viable. Select the alternative with the PW or AW value that is numerically larger.