ATCF w/ Depreciation. Tax Savings Due to Depreciation. Timing of Expenses. PW of Tax Savings. Why Study Depreciation Methods?

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1 13: Depreciation and Basic Tax Considerations Taxes are a major component of any project's cash flows, particularly income tax Taxable income (TI) is the income on which taxes are paid Not reduced by initial cost (IC) of purchases Make yearly depreciation charges to reduce TI $24, IC with $3, salvage in 3 yrs Might reduce yearly TI for next 3 yrs by Tax laws complex Introduction $7, = (24, 3,) / 3 Professional help advisable Introduction 13.1 Overview of Depreciation Equipment used for business purposes with life of at least 1 year must be depreciated Purchase cost itself not an expense Expense is any item deductible from TI Money spent for equipment, but company still owns equipment Depreciation expenses not cash flows themselves, but accounting charges that affect the very real cash flows for taxes 3, 9,4 24, Before Taxes Depreciation and Taxes 3, 6,58 24, After Taxes, No Depreciation Consider spending $24, for special tooling Yearly savings of $9,4 for 3 years Salvage of $3, 3, 8,68 24, After Taxes, Depreciation Note magnitude of changes caused by taxes 3, 9,4 24, Before Taxes ATCF w/o Depreciation 3, 6,58 24, After Taxes, No Depreciation Taxes at 3% Yearly TI = $9,4 Taxes = $2,82 = 9,4(.3) ATCF = BTCF + Cash flow for taxes ATCF = $6,58 = 9,4 2,82

2 24, Before Taxes ATCF w/ Depreciation 9,4 3, Yearly depreciation expense w/ SL Depr D1 = D2 = D3 = $7, = (24, 3,) / 3 Yearly TI = $2,4 = 9,4 7, Taxes = $72 = 2,4(.3) ATCF = $8,68 = 9,4 72 8,68 3, 24, After Taxes, Depreciation Reduces taxes, but still not as good as BTCF Tax Savings Due to Depreciation Depreciation charges or expenses reduce TI Yearly Tax Savings W/O Depreciation Tax =.3 9,4 W/ Depreciation Tax =.3 (9,4 7,) Without With Tax Saving =.3 7, Depr Tax Saving = Tax Rate $2,1 =.3 7, Depr Expense Timing of Expenses Different depreciation methods affect the timing and amount of depr expenses SL (straight line) and 2% DB (declining balance) Same total expenses of $21, Different timing Depr Expenses Yr SL 2% DB 1 7,. 16,. 2 7,. 5,. 3 7,.. PW of Tax Savings PW of Tax Savings Yr SL 2% DB 1 7,. 16,. 2 7,. 5,. 3 7,.. PW 5, ,63.31 PW =.3 D1(P F, 1%, 1) +.3 D2(P F, 1%, 2) +.3 D3(P F, 1%, 3) 2% DB has effect of having $38.82 ( ,222.39) extra at time for a marginal investment, so it is preferred in this case Why Study Depreciation Methods? Taxes are large cash flows that cannot be ignored Depr expenses reduce cash flows for taxes Choice of method affects PW of tax savings 13.2 Basics of Depreciation Accounting

3 Different methods use various formulas to compute depreciation charges Straight Line Methods and Formulas Declining Balance Declining Balance w/ Switch to SL MACRS and modifications Objective is to have a systematic and legal way to compute taxes All methods use following terms and notation IC Installed Cost Includes purchase, freight, sales tax, and installation costs BV Initial Book Value First value recorded in accounting books Book values are the values of assets in accounting records Book value is a matter of law, and there is no legal expectation that an asset's fair market value equals its BV Companies frequently and legally have one set of book values for tax purposes and another set for reporting to management and investors BV is basis of subsequent calculations Aka unadjusted basis or simply basis D j Depreciation Charge or Expense Deduction from TI at time j given for wear and obsolescence of equipment Charged as an expense for tax purposes Expenses are items deductible from TI Depreciation not a cash flow Causes cash flows of tax savings Book Value at Time j Depreciation Life or Recovery Period BVj Value of asset at time j in accounting books Equals BV minus all depr charges to date Aka adjusted basis Costs of capital improvements, such as major overhauls, increase adjusted basis Minor improvements, such as routine maintenance, are expensed n Legal time period over which asset is depreciated Aka recovery period during which company recovers the IC for tax purposes Useful life might be different

4 SV Salvage Value Legal value under IRS regulations used in computing depreciation charges Actual salvage value is the amount realized and can be different Basis or initial book value BV = IC Adjusted basis or book value after j years or Computing Book Values BVj = BV D1 D2 Dj BVj = BV j 1 Dj Depr charges may never force BV < SV, the legal salvage value: BV j SV Straight Line Depreciation Example 13.1 Straight Line Depreciation Charges for every year given by Dj = (IC SV ) / n, j = 1, 2,, n Sum of charges through time j equals jd j, so BVj = IC jdj Plots as straight line versus time Can also always use BVj = BV j -1 Dj $24, IC with $3, SV in 3 years Basis is $24, Depreciation charges are Dj = 7, = (24, 3, ) / 3, j = 1, 2, 3 Adjusted bases are BV1 = $17, = 24, 7, BV2 = $1, = 17, 7, BV3 = $3, = 1, 7, Declining Balance Each charge a constant percentage of the preceding year's book value, until SV is reached Faster write-off or decrease in book value than SL, so known as accelerated method Increases tax savings PW if tax rate constant PW of closer flows always larger Percentage equals the declining balance rate (DBR) divided by the recovery period p = DBR / n DBR depends on type of asset being depreciated 1%, 125%, 15%, 175%, and 2% (double) Formulas Percentage multiplier p is DBR / n Each year's depreciation expense is D j = pbvj -1, j = 1, 2,, n As long as BVj SV Book values are given by the general formula BVj = BV j -1 Dj Or substitute for Dj to obtain BVj = (1-p)BVj-1

5 Adjusting for Salvage Value Continue depreciating until the computed BVk in year k is less than SV BVk -1 is last BV larger than SV, so let Dk = BVk -1 SV This makes the final BVk equal to SV All depr charges after year k are $ Ex % DB Not Limited by the SV $24, IC with $ salvage in 3 years 2% DB depreciation, so p = 2/3 j D j BV j 24,. 1 16,. = 24,.(2/3) 2 5, = 8,.(2/3) 3 1, = 2,666.67(2/3) 8,. = 24,.(1 2/3) 2, = 8,(1 2/3) = 2,666.67(1 2/3) Will never reach SV = $ w/ DB Ex % DB Limited by the SV Ex % DB Limited by the SV Adjust $24, IC with $3, salvage in 3 years 2% DB depreciation, so p = 2/3 j D j BV j 24,. 1 16,. = 24,.(2/3) 2 5, = 8,.(2/3) 8,. = 24,.(1 2/3) 2, = 8,(1 2/3) $24, IC with $3, salvage in 3 years 2% DB depreciation, so p = 2/3 j D j BV j 24,. 1 16,. = 24,.(2/3) 2 5, = 8,.(2/3) 5,. = 8,. 3,. 8,. = 24,.(1 2/3) 2, = 8,.(1 2/3) 3,. = 8,. 5,. 3. 3,. = 3,.. Switching from DB to SL If DB does not reach SV, then all available depr not used during the depreciation life Occurs under current law where SV = $ Switching to SL remedies this problem Treat BV at time of switch as IC and remaining life as recovery period If switch at time j 1, there are n ( j 1) years left, so Dj = Dj + 1 = = Dn = (BVj -1 SV ) / (n j + 1) Example 13.4 Simple Switch from DB to SL BV = $24,, SV = $, DBR = 2%, n = 3 Use DB for year 1: D1 = $16,= 24,(2/3) BV1 = $8,= 24, 16, Switch to SL at time 1 so D2 and D3 are SL D2 = D3 = $4, = (8, ) / (3 1) BV2 = $4, = 8, 4, BV3 = $ = 4, 4,

6 Switch to Max PW of Tax Savings If tax rate same each year, max PW of tax savings with largest early depr charges possible DB initially, then possibly switch to SL BV j DB Best SL Switch Early SL Switch Faster BV decline larger D j DB D j get smaller n j Timing the Switch DB charges always get smaller, so if tax rate constant then switch to SL when Charge from switch to SL Dj, SL Dj, DB Charge from DB For SV = $, charge first D j using SL when (BVj -1 ) / (n j + 1) pbvj -1 j n n /DBR + 1 Switch at j -1 to charge Dj, SL for year j If tax rate not constant or SV not $, then trial and error must be used Example 13.5 Timing the Switch from DB to SL BV = $24,, SV = $, DBR = 2%, n = 3 Charge first D j using SL when j n n /DBR + 1 j 2.5 = 3 3/2 + 1 First SL charge is D 3, so switch at time 2 D 1 and D 2 for DB = $16,. and $5, BV2 = $2, = 24, 16, 5, D3 = $2, = (2, ) / (3 2) BV3 = $ = 2, , MACRS and Personal Property Name and Legislation Modified Accelerated Cost Recovery System (MACRS, pronounced "makers") Tax Reform Act of 1986 Basis of current structure and logic Adjustments in rates, amounts, etc. Job Creation and Worker Assistance Act of 22 Jobs and Growth Tax Relief Reconciliation Act of 23 Economic Stimulus Act of 28 American Recovery and Reinvestment Act of 29 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 21 Two general categories of property Intangible software, copyrights, patents Tangible See or touch, buildings or equip Two classifications of tangible property Real Types of Properties buildings: use SL depreciation Personal anything else, such as equipment for projects: use DB with optimal switch to SL

7 MACRS Depr Procedure for Personal Property DB with optimal switch to SL for personal DBR = 2% for recovery period 1 yrs DBR = 15% for recovery period > 1 yrs j n n /DBR + 1 Procedure Determine property class or recovery period For each class, multipliers of BV in table D j = r j BV r j originally called recovery rate in 1986 Rates sometimes adjusted Mid-Year Convention MACRS generally assumes that personal property is purchased or disposed at mid-year Half-year s depr allowed during the first and last years of recovery Consider a 5-year property 5 years Recovery period is assumed to be from time.5 to time 5.5, so there are depreciation charges at times 1, 2, 3, 4, 5, and 6 Causes n + 1 charges for n yr recovery period 3 Year Personal Property Classes 5 Year Personal Property Classes Special handling devices for food and beverage manufacture Special tools for manufacturing fabricated metal, motor vehicles, rubber, glass Truck tractors and racehorses j r j Computers and peripherals, office machinery Research and experimentation equipment Oil and gas drilling, construction, apparel manufacturing equipment Cars (subject to limits), trucks, and buses j r j Year Personal Property Classes Any item not placed in a specific property class Office furniture and equipment such as desks, files, or safes Machinery for wood products and furniture Oil and gas exploration and production equipment Waste reduction and resource recovery plants j r j Year Personal Property Classes Docks and ship building equipment Equipment for grain, sugar, and vegetable oil products Durable goods manufacturing and oil refining equipment j r j

8 15 Year Personal Property Classes Pipelines Municipal wastewater treatment plants Land improvements such as shrubbery, fences, or roads, but not land itself j rj Year Personal Property Classes Electric, gas, water and steam utilities j rj Ex 13.6 MACRS Depr for Personal Property Computer and peripheral equipment for distance learning IC is $1, with actual salvage value estimated to be $1, in 4 years Kept for entire recovery period j r j Determine property class: 5 years Look up adjusted recovery rates for n = Ex 13.6 Computations Use D j = r j BV D1 = $2, =.2(1,) D2 = $3,2 =.32(1,) D3 = $1,92 =. 192 (1,) D4 = $1,152 =.1152(1,) D5 = $1,152 =.1152(1,) D6 = $576 =.576(1,) Dj > 6 = $ since recovery period has ended Amount realized not used in MACRS Six depr charges for 5 year recovery period Closer Look at Recovery Rates Exact computation of rates in Appendix Tables contain rates so that Charge for year 1 is 1/2 of full charge Full charge for years 2, 3,, n Charge for year n +1 is 1/2 of full charge For n = 5 Yr.5 Yr yrs Rates in tables rounded to sum to 1% Taxpayers can elect to compute Sometimes required Early disposal occurs in years 2 through n Assume 1/2 year of use (even if 1 day!) Use.5r j instead of r j No charges after disposal or end of recovery period For 5 year property Early Disposals Early disposals can occur in yrs 2, 3, 4, or 5 For year 6, rate in table already for 1/2 yr Assume 1/2 year of use If last quarter purchases are 4% or more of all purchases, then must use a mid-quarter convention instead of a mid-year convention

9 Ex 13.7 Early Disposal of MACRS Personal Prop Same $1, equipment w/ n = 5 Asset disposed of in year 3 First two years same as before 1/2 of normal charge for yr of early disposal D3 = $96 = (1/2)(.192)(1,) Dj > 3 = $ since disposal has occurred Asset disposed in year 6 Rate for last year of recovery period already assumes 1/2 year of use D6 = $576 =.576(1,) Dj > 6 = $ since recovery period has ended 13.4 MACRS and Real Property Introduction Real property frequently involves large sums of money Use more precise mid-month convention for purchases and disposals SL depreciation with SV = $ used Residential property uses a recovery period of n = 27.5 yrs Non-residential has n = 39 yrs Recovery Rates for Initial Years Full year's residential depr is (1/27.5)BV Rounded to 3.636%BV or 3.637%BV D1 =.3636 BV D11 =.3637 BV First year depr of residential property bought in month 9 of a company's tax year Tax year not always same as calendar year Legal mid-month purchase time is month 8.5 Legally use property for 3.5 = 12 D1 =.161 BV = (3.5/12)(1/27.5) BV 8.5 mos Same concepts for non-residential except 1/39 When Recovery Period Ends Residential recovery period ends 27 years and 6 months after legal purchase Purchase in mo 9 becomes at mo 8.5 (28 yrs, 2.5 mo) = 8.5 mo + (27 yrs, 6 mo) 28 yrs and 2.5 mo Mo 3 of Yr 29 in table Month 8.5 of year 1 27 yr, 6 mo Month 2.5 of year 29 Yr Yr 29 D29 =.758 BV = (2.5/12)(1/27.5)BV Same concepts for non-residential except 1/39 Real Property Recovery Rates n = 27.5 Month in Which Put in Service j = Even Odd n = j =

10 Any month before end of recovery period Early residential disposal in month 5 of year 1 Legally use for 4.5 months in year 1 D1 = (4.5/12)(1/27.5)BV D11, D12, = Early Disposal Hint Always use tables for first year it s easier Use tables if disposal reaches recovery period If before, (mid-month/ 12) (1/27.5 or 1/39) Ex 13.8 MACRS Depr for Residential Real Prop Residential, BV = $1,, in mo 3 of tax yr Dj for disposals in mos 4, 9, & 11 of yr 28? Recovery period Begins month 2.5 Ends (27 yr, 8.5 mo) = 2.5 mo + (27 yr, 6 mo) 27 yr and 8.5 mo mo 9 of year 28 Disposals in mos 9 and 11 of year 28 Both have reached end of recovery period Tabular recovery rate for year 28 with purchase in month 3 is r 28 = 2.576% D28 = $25,76 =.2576 BV Ex 13.8 Early Disposal Disposal in mo 4 of yr 28 Legally occurs at (27 yr, 3.5 mo) Recovery period ends (27 yr, 8.5 mo) r 28 = (3.5/12)(1/27.5) D 28 = $1,66 = (3.5/12)(1/27.5)BV Ex 13.9 MACRS Depr for Non-Res Real Prop Building and land cost $1,2, In 45 yrs salvage building for $1, Land ($2, of $1,2, purchase price) never depreciated BV = $1,, for building Legal SV is $, so ignore the $1, Tax year begins in Jan, buy in March => mo 3 Ex 13.9 Depr Charges MACRS Dj if asset kept entire recovery period? n = 39 j = D1 = $23,33 = 1,,(.233) D2 = = D39 = $25,64 = 1,,(.2564) D4 = $5,35 = 1,,(.535) If disposed in May of yr 3, the fifth mo of tax yr? D1 and D2 as above D3 = $9, = (4.5/12)(1/39)1,, 13.5 Other Tax Deductions

11 Section 179 of Internal Revenue Code Most recent revision: 21 Primarily for companies with total purchases under $2,K Expense up to $5K of installed cost immediately Deduct expense from basis, then use MACRS depreciation Example 13.1 Section 179 Expense Start w/ $1,975K of total purchases and $485K of S179 used Now make $2K purchase in 5 yr class Total purchases = $1,995K < $2,K Can only expense $15K (5K 485K) of S179 Adjust basis by expense to $5K = 2 15 Multiply $5K by recovery rates r = 2.% (from tables) 1 D = $1K = (.2) 5K 1 Total yr 1 deduction = $16K = 15K + 1K D = r 5K, j > 1 j j Bonus Depreciation Most recent revision: 21 Occasionally occurs in response to economic conditions Extra depreciation, usually in first year If Section 179 expense used, apply it first Adjust basis by extra depreciation Example Bonus Depreciation Purchase 5 year property for $115K and apply $15K S179 Adjust basis to $1K (115K 15K) Bonus depreciation = 5% for first year D = $5K = 5% (1K) Bonus Adjust basis by bonus depr to $5K = 1K 5K Multiply adjusted basis by recovery rates r =.2 (from tables) 1 D 1 = $1K = (.2) 5K Total yr 1 deduction = $75K = 15K + 5K + 1K D j = r j 5K, j > 1 Options within MACRS MACRS General Depreciation System (GDS) Most common form As shown in preceding sections Can elect to delay deductions if anticipate increasing tax rate Use 15% DB instead of 2% or use SL Depletion Make depletion charges as natural resource is produced and depletes the reserves Similar to depr charges as equipment wears out MACRS Alternative Depreciation System (ADS) Delays deductions by using SL instead of 2% DB over longer recovery periods

12 State and Local Taxes Income, property, sales Some state income tax systems similar to federal, but with different rates States can use non-macrs depreciation systems Deduct state and local taxes from federal taxable income whenever allowed, such as income and property taxes, but not sales taxes 13.6 Tax Credits Basics A depreciation charge of $1, for a taxpayer in the 27% bracket d ecreases taxes by $27, 27% of $1, A tax credit of $1, for a taxpayer in any bracket d ecreases taxes by $1, Not a consistent history of tax cred its for project equi p ment Example 13.1 Equipment Tax Credit 5% tax credit on 3-yr property w/ $1, IC Credit equals $5 (5% 1,) at t = Adjust BV by credit to $9,5 before depr Adjustments in BV not always required 25% tax bracket and MACRS t Tax Savings $5. = 5% 1, 1 $ = 9, % 25% 2 $ = 9, % 25% 3 $ = 9, % 25% 4 $ = 9,5 7.41% 25%