Depreciation and Income Taxes 9/18/2018 7:32 AM Chapter 7 Depreciation and Income Taxes Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology Depreciation 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Depreciation Decrease in value of physical properties with passage of time and use Accounting concept establishing annual deduction against before-tax income to reflect effect of time and use on asset’s value in firm’s financial statements to match yearly fraction of value used by asset in production of income over asset’s economic life Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Property is Depreciable if it Must: be used in business or held to produce income have a determinable useful life which is longer than one year wear out, decay, get used up, become obsolete, or lose value from natural causes not be inventory, stock in trade, or investment property Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology DEPRECIABLE PROPERTY Tangible: can be seen or touched personal property - includes assets such as machinery, vehicles, equipment, furniture, etc... real property - anything erected on, growing on, or attached to land (Since land does not have a determinable life itself, it is not depreciable) Intangible: personal property, such as copyright, patent or franchise Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology When depreciation starts and stops? Depreciation starts when property is placed in service for use in business or for production of income Property is considered in service when ready and available for specific use, even if not actually used yet Depreciation stops when cost of placing it in service is removed or it is retired from service Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Adjusted cost basis: allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation and depletion deductions Basis, or cost basis: called unadjusted cost initial cost of acquiring an asset, plus sales tax, transportation, and normal costs of making asset serviceable Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Book Value (BV): Worth of depreciable property as shown on accounting records Represents amount of capital remaining invested in property and must be recovered in future through accounting 𝐵𝑉 𝑘 =adjusted cost basis− 𝑗=1 𝑘 depreciation deduction Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Market Value (MV) Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact approximates present value of what will be received through ownership of property, including time-value of money (or profit) Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Recovery Period: Number of years over which basis of property is recovered through accounting process. Normally the useful life for classical methods Property class for General Depreciation System (GDS) under MACRS Class Life for Alternative Depreciation System (ADS) Recovery Rate: Percentage for each year of MACRS recovery period used to calculate an annual depreciation deduction. Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Salvage Value (SV): Estimated value of property at the end of useful life. expected selling price of property when asset can no longer be used productively net salvage value used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value with classical methods of depreciation, estimated salvage value is established and used with MACRS, the salvage value of depreciable property is defined to be zero Dr. Mohammad Abuhaiba, PE

7.2 Depreciation Concepts and Terminology 9/18/2018 7:32 AM 7.2 Depreciation Concepts and Terminology Useful Life: Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life. Dr. Mohammad Abuhaiba, PE

7.3 The Classical Depreciation Methods 9/18/2018 7:32 AM 7.3 The Classical Depreciation Methods The following terms are used in the classical (historical) depreciation method equations: N = depreciable life of the asset in years B = cost basis, including allowable adjustments dk = annual depreciation deduction in year k (1< k <N) dk* = cumulative depreciation through year k BVk = book value at the end of year k BVN = book value at the end of the depreciable (useful) life SVN = salvage value at the end of year N R = the ratio of depreciation in any one year to the BV at the beginning of the year Dr. Mohammad Abuhaiba, PE

7.3 The Classical Depreciation Methods Straight-line (SL) method 9/18/2018 7:32 AM 7.3 The Classical Depreciation Methods Straight-line (SL) method Assumes constant amount is depreciated each year over depreciable (useful) life dk = ( B - SVN ) / N dk* = kdk for 1 < k < N BVk = B - dk* This method requires an estimate of the final SV (also the final book value at the end of year N ) Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-1 A laser surgical tool has a cost basis of $200,000 and a five-year depreciable life. The estimated SV of the laser is $20,000 at the end of five years. Determine the annual depreciation amounts using the SL method. Tabulate the annual depreciation amounts and the book value of the laser at the end of each year. Dr. Mohammad Abuhaiba, PE

7.3 The Classical Depreciation Methods Declining Balance (DB) Method 9/18/2018 7:32 AM 7.3 The Classical Depreciation Methods Declining Balance (DB) Method Sometimes called constant percentage method or Matheson formula Assumed annual cost of depreciation is fixed percentage of BV at BOY R = 2 / N when 200% declining balance used R = 1.5 / N when 150% declining balance used d1 = B (R) dk = B (1 - R )k - 1 (R) dk* = B [1 - (1 - R )k ] BVk = B (1 - R )k BVN = B (1 - R )N Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-2 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 SV of the saw is zero at the end of 10 years. Use the DB method to calculate the annual depreciation amounts when R=2/N (200% DB method) R=1.5/N (150% DB method) Dr. Mohammad Abuhaiba, PE

7.3 The Classical Depreciation Methods Declining Balance (DB) Method 9/18/2018 7:32 AM 7.3 The Classical Depreciation Methods Declining Balance (DB) Method Because declining balance method never reaches BV = 0, it’s permissible to switch from this to straight-line method so asset’s SVN will be zero or other desired value. Switchover occurs in the year in which a larger Depreciation amount is obtained from SL method Table 7-1 Dr. Mohammad Abuhaiba, PE

7.3 The Classical Depreciation Methods Units of Production Method 9/18/2018 7:32 AM 7.3 The Classical Depreciation Methods Units of Production Method Decrease in value is mostly a function of use 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛= 𝐵 − 𝑆𝑉 𝑁 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡𝑠 Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-3 A piece of equipment used in a business has a basis of $50,000 and is expected to have a $10,000 SV when replaced after 30,000 hours of use. Find its depreciation rate per hour of use, and find its BV after 10,000 hours depreciation. Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) The principal method for computing depreciation deductions for property in engineering projects. Applies to most tangible depreciable property placed in service after December 31, 1986 SVN is defined to be 0 useful life estimates are not used directly in calculating depreciation amounts Consists of two systems for computing depreciation deductions: The General Depreciation System (GDS) The Alternative Depreciation System (ADS) Provides longer recovery period and uses only straight-line method of depreciation Assets depreciated under ADS include property placed in any tax-exempt use and property used predominantly outside the U.S. Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Information NEEDED to calculate macrs depreciation The cost basis The date the property was placed in service The property class and recovery period The MACRS depreciation used (GDS or ADS) The time convention that applies (half year) Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Property Class and recovery Period General Depreciation System (GDS) Basic Information Tangible depreciable property assigned to one of six personal property classes (3, 5, 7, 10, 15 and 20-year) Corresponds to GDS recovery period personal depreciable property not corresponding to these periods is considered 7-yr property class. Real property assigned to two real property classes: nonresidential real property residential rental property. GDS recovery period is 39 years for nonresidential real property (31.5 years if in service before May 13, 1993) and 27.5 years for residential rental property. Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Property Class and recovery Period Alternative Depreciation System (ADS) Basic Information ADS recovery period for tangible personal property is normally the same as the class life of the property, with some exceptions (i.e., asset class 00.12 and 00.22 ) Any tangible personal property that does not fit into one of the asset classes is depreciated using a 12-year ADS recovery period ADS recovery period for nonresidential real property is 40 years Table 7.2: MACRS Class Lives and Recovery Periods, IRS Publication 946 Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Depreciation methods, Time Convention, and recovery Period Depreciation Method Personal Property Class Approach GDS 3-, 5-, 7-10-year 200% DB method with switch to SL when greater deduction 15 & 20 year 150% DB method with switch to SL when greater deduction Residential & real rental SL over fixed GDS recovery periods ADS personal & real SL over fixed ADS recovery periods Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Depreciation methods, Time Convention, and recovery Period Half-year Time conventions All assets placed in service during the year are treated as if use began in the middle of the year: 1/2-year depreciation is allowed If asset is disposed of before the full recovery period is used, only half of the normal depreciation deduction can be taken for that year Table 7.3: GDS Recovery Rates (rk), for the Six Personal Property Classes, IRS Publication 534 Dr. Mohammad Abuhaiba, PE

7.4 Modified Accelerated Cost Recovery System (MACRS) 9/18/2018 7:32 AM 7.4 Modified Accelerated Cost Recovery System (MACRS) Table 7-4: MACRS (GDS) Property Classes and primary methods for calculating depreciation deductions GDS Property Class and Method Class life Special rules 3-year, 200% DB with switchover to SL ≤ 4 yr 5-year, 200% DB with switchover to SL 4<N<10 7-year, 200% DB with switchover to SL 10<N<16 10-year, 200% DB with switchover to SL 16<N<20 15-year, 150% DB with switchover to SL 20<N<25 20-year, 150% DB with switchover to SL ≥25 27.5 year, SL N/A 39-year, SL Dr. Mohammad Abuhaiba, PE

Ascertain property class; SL = -------------------------- MACRS DEPRECIATION GDS OR ADS ? 9/18/2018 7:32 AM GDS ADS Ascertain property class; Same as recovery period for personal Ascertain recovery period Compute depreciation amount; Asset’s cost basis SL = -------------------------- Recovery period Obtain recovery rates Compute depreciation deduction in year k (dk) by multiplying cost basis by recovery period. Compute depreciation deduction in year k (dk) Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-4 A firm purchased and places in service a new piece of semiconductor manufacturing equipment. The cost basis for the equipment is $100,000. Determine The depreciation charge permissible in the fourth year, The BV at the end of the fourth year The cumulative depreciation through the third year The BV at the end of the fifth year if the equipment is disposed of at that time. Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-5 In May 2005, your company traded in a computer and peripheral equipment, used in its business, that had a BV at that time of $25,000. A new faster computer system having a fair MV of $400,000 was acquired. Because the vendor accepted the older computer as a trade-in deal was agreed to whereby your company would pay $325,000 cash for the new computer system. What is the GDS property class of the new computer system, How much depreciation can be deducted each year based on this class life? (Refer to figure 7-1) Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-6 A large manufacturer of sheet metal products in the Midwest purchased and placed in service a new modern, computer-controlled flexible manufacturing system for $3.0 million. Because this company wouldn’t be profitable until the new technology had been in place for several years, it elected to utilize the ADS under MACRS in computing its depreciation deductions. Thus, the company could slow down its depreciation allowances in hopes of postponing its income tax advantages until it became a profitable concern. What depreciation deduction can be claimed for the new system? Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example7-7 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 buss 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. First, we must calculate the cost basis. The basis is the original purchase price of the bus plus the BV of the old bus that was traded in. Thus, the basis is $85,000 + $10,000, or $95,000. We need to look at Table 7-2 and find buses, which are asset class 00.23. hence, we find that buses have a nine-year class (useful) life, over which we depreciate the bus with historical methods discussed in section 7.3, and a five year GDS recovery period. Dr. Mohammad Abuhaiba, PE

7.6 Introduction to Income Taxes Types of Taxes 9/18/2018 7:32 AM 7.6 Introduction to Income Taxes Types of Taxes Income taxes: assessed as a function of gross revenues minus allowable deductions levied at federal, most state, and some municipal governments Property taxes: assessed as a function of owned property value; independent of income or profit of firm levied at municipal, county, and / or state level Sales taxes: assessed on purchases of goods and services independent of gross income or profits relevant to engineering studies as added cost Excise taxes: assessed on sale of certain nonessential goods and services independent of business income and profit cost ultimately to consumer, despite original target Dr. Mohammad Abuhaiba, PE

7.6 Introduction to Income Taxes Before Tax and After Tax MARR 9/18/2018 7:32 AM 7.6 Introduction to Income Taxes Before Tax and After Tax MARR (Before Tax MARR ) [ ( 1- effective income tax rate ) ]≈After Tax MARR 𝐵𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑀𝐴𝑅𝑅= 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑀𝐴𝑅𝑅 (1−𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) If the asset is non-depreciable and there are no gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact Otherwise, some degree of error is introduced, since the factors cited affect amount and timing of income tax payments Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM 7.6 Introduction to Income Taxes Taxable Income of Corporations (Business Firms) Calculate Gross Income Gross Profits (revenues from sales - cost of goods sold) + income from dividends, interest, rent, royalties, and gains (losses) from sale or exchange of capital assets Deduct all ordinary and necessary operating expenses to conduct business Include interest but exclude capital investments Deduct depreciation taxable income = gross income - all expenses - depreciation Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-8 A company generates $1,500,000 of gross income during its tax year and incurs operating expenses of $800,000. Property taxes on business assets amount to $48,000. The total depreciation deduction for the tax year equal $114,000. What is the taxable income of this firm? Dr. Mohammad Abuhaiba, PE

7.6 Introduction to Income Taxes Net Income After Taxes (NIAT) 9/18/2018 7:32 AM 7.6 Introduction to Income Taxes Net Income After Taxes (NIAT) NIAT = NIBT - income taxes Dr. Mohammad Abuhaiba, PE

7.7 Effective (Marginal) Corporate Income Tax Rate 9/18/2018 7:32 AM 7.7 Effective (Marginal) Corporate Income Tax Rate As personal income tax rates are based on income brackets, so, too, is corporate income tax Depending on the bracket a firm’s income falls within, the marginal federal rate can vary from 15% to a maximum of 39% (for incomes between $100,000 and $335,000) Incomes above $18,333,333 are taxed at a flat rate of 35% TRA 86 responsible for lowering maximum rate from 46% to 35% Also created alternative minimum tax (AMT) Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-9 Suppose that a firm for a tax year has a gross income of $5,270,000, expenses (excluding capital) of $2,927,500, and depreciation deduction of $1,874,300. What would be its taxable income and federal income tax for the tax year, based on Equation (7-14) and Table 7-5? Dr. Mohammad Abuhaiba, PE

7.7 Effective (Marginal) Corporate Income Tax Rate 9/18/2018 7:32 AM 7.7 Effective (Marginal) Corporate Income Tax Rate t = Federal rate + (1-Federal rate)(state rate) Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-10 A small corporation is expecting an annual taxable income of $45,000 for its tax year. It is considering an additional capital investment of $100,000 in an engineering project, which is expected to create an added annual net cash flow (revenue minus expenses) of $35,000 and an annual depreciation deduction of $20,000. What is the corporation’s federal income tax liability: Without the added capital investment? With the added capital investment? Dr. Mohammad Abuhaiba, PE

7.8 Gain (Loss) on Disposal of an Asset 9/18/2018 7:32 AM 7.8 Gain (Loss) on Disposal of an Asset [GAIN (LOSS) ON DISPOSAL]N = MVN - BVN If gain, referred to as depreciation recapture Tax for gain (loss) is usually the same as ordinary income gain (loss) effective income tax rate, t For capital asset sold or exchanged, gain (loss) referred to as capital gain (loss) capital assets are stocks, bonds, gold, silver, other metals, and real property Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-11 A corporation sold a piece of equipment during the current tax year for $78,600. The accounting records show that its cost basis, B, is $190,000 and the accumulated depreciation is $139,200. Assume that the effective income tax rate as a decimal is 0.40 (40%). Based on this information, what is The gain (loss) on disposal? The tax liability (or credit) resulting from this sale? The tax liability (or credit) if the accumulated depreciation was $92,400 instead of $139,200? Dr. Mohammad Abuhaiba, PE

7.9 General Procedure for Making After Tax Economic Analysis 9/18/2018 7:32 AM 7.9 General Procedure for Making After Tax Economic Analysis NIBT = (Rk – Ek- dk) Tk = - t (Rk – Ek- dk) Rk = revenues (and savings from the project: cash inflow from project during period ‘k’ Ek = cash outflows during year k for deductible expenses and interest dk = sum of all noncash, or book costs during year ‘k’, such as depreciation and depletion t = effective income tax rate on ordinary income (federal, state and other); assumed to remain constant during the study period Tk= income taxes paid during year ‘k’ Dr. Mohammad Abuhaiba, PE

7.9 General Procedure for Making After Tax Economic Analysis 9/18/2018 7:32 AM 7.9 General Procedure for Making After Tax Economic Analysis BTCFk = Rk – Ek ATCFk = BTCFk + Tk Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-12 Suppose that as asset with a cost basis of $100,000 and an ADS recovery period of five years is being depreciated under the alternative depreciation system ADS of MACRS, as follows: If the firm’s effective income tax rate remains constant at 40% during this six-year period, what is the PW of after-tax savings resulting from depreciation when MARR = 10% per year (after taxes)? Year 1 2 3 4 5 6 Depreciation deduction $10,000 $20,000 Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-13 The asset in Example 7-12 is expected to produce net cash inflows (net revenues) of $30,000 per year during the six-year period, and its terminal MV is negligible. If the effective income tax rate is 40%, how much can a firm afford to spend for this asset and still earn the MARR? What is the remaining of any excess in affordable amount over the $100,000 cost basis given in example 7-12? [Equals the after-tax PW] Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-14 Here we refer back to the chapter opener where the question of the after-tax cash of electricity production was raised. For the PennCo Plant, the annual fuel expense will be $191,346,432 per year. The operating and maintenance expenses will be $112,128,000 per year, and the carbon tax will be $73,805,052 per year. The total annual expenses of operating the plant will therefore be $377,279,484. Armed with these cost estimates, we can calculate the after-tax cost of the plant by using the template of figure 7-4 (all numbers are millions of dollars). Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-15 Certain new machinery, when placed in services, is estimated to cost $180,000. It is expected to reduce net annual operating expenses by $36,000 per year for 10 years and to have a $30,000 MV at the end of the 10th year. Develop the ATCFs and the BTCFs. Calculate the before-tax and after-tax IRR. Assume that the firm is in the federal taxable income bracket of $335,000 to $10,000,000 and that the state income tax rate is 6%. State income taxes are deductible from federal taxable income. This machinery is in the MACRS (GDS) five-year property class. Calculate the after-tax PW when the after-tax MARR = 10% per year. In this example, the study period is 10 years, but the property class of the machinery is 5 years. Solve by hand and by spreadsheet. Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-16 Suppose the machinery in example 7-15 had been classified in the 10-year MACRS (GDS) property class. Calculate the new after-tax PW and the after-tax IRR. Why are these results different than the results of example 7-15? Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-17 A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will be used to produce income (through rental) of $20,000 per year for only four years. At the end of year four, the equipment will be sold for a negligible amount. Estimated annual expenses for upkeep are $3,000 during each of the four years, and the firm’s effective income-tax rate is 40%. If the after-tax MARR is 7% per year, should the equipment be purchased? Rework the problem, assuming that the equipment is placed on standby status such that depreciation is taken over the full MACRS recovery period. Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-18 The Ajax Semiconductor company is attempting to evaluate the profitability of adding another integrated circuit production line to its present operations. The company would need to purchase two or more acres of land for $275,000 (total). The facility would cost $60,000,000 and have no net MV at the end of five years. The facility could be depreciated using a GDS recovery period of five years. An increment of working capital would be required, and its estimated amount is $10,000,000. Gross income is expected to increase by $30,000,000 per year for five years, and operating expenses are estimated to be $8,000,000 per year for five years. The firm’s effective income tax rate is 40%. Set up a table and determine the ATCF for this project. Is the investment worthwhile when the after-tax MARR is 12% per year? Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-19 An engineering consulting firm can purchase a fully configured computer-aided design (CAD) workstation for $20,000. It is estimated that the useful life of the workstation is seven years, and its MV is seven years should be $2,000. Operating expenses are estimated to be $40 per eight hour workday, and maintenance will be performed under contract for $8,000 per year. The MACRS (GDS) property class is five years, and the effective income tax rate is 40%. As an alternative, sufficient computer time can be leased from a service company at an annual cost of $20,000. If the after-tax MARR is 10% per year, how many workdays per year must the workstation be needed in order to justify leasing it? Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-20 A firm must decide between two system designs, S1 and S2, whose estimates 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 $10,000 Useful life (years) 7 6 MV at the end of useful life $30,000 $60,000 Annual revenues less expenses $20,000 $40,000 Dr. Mohammad Abuhaiba, PE

7.11 Economic Value Added (EVA)c 9/18/2018 7:32 AM 7.11 Economic Value Added (EVA)c An economic measure for estimating wealth creation potential of capital investments: EVA = (Net Operating Profit After Taxes )k – (Cost of Capital Used to Produce Profit)k EVA = NOPATk – i . BVk-1 Where k = index for year in question (1 < k < N) i = after-tax MARR based on firm’s cost of capital BVk-1= Beginning of year book value N = the study (analysis) period in years Dr. Mohammad Abuhaiba, PE

7.11 Economic Value Added (EVA)c 9/18/2018 7:32 AM 7.11 Economic Value Added (EVA)c NOPATK = ( 1 –t ) ( Rk – Ek –dk) EVAk = ( 1 –t ) (Rk – Ek –dk) – i . BVk-1 When k > 0, ATCFk = ( 1 –t )(Rk – Ek –dk) + dk When k = 0, ATCF0 = BV0 ATCFk = EVAk + i . BVk + dk dk is the sum of all noncash, or book costs during the year k, such as depreciation or depletion Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Example 7-21 Consider the following proposes capital investment in an engineering project and determine its Year-by-year ATCF, After-tax AW, Annual equivalent EVA. Proposed capital investment =$84,000 Salvage value (end of year four) =$0 Annual expenses per year =$30,000 Gross revenue per year =$70,000 Depreciation method =Straight line Useful life =four years Effective income tax rate (t) =50% After-tax MARR (i) =12% per year Dr. Mohammad Abuhaiba, PE

9/18/2018 7:32 AM Home Work Assignment 6, 11, 16, 21, 26, 31, 37, 42 Due Saturday 3/12/2011 Dr. Mohammad Abuhaiba, PE