Mc Graw Hill DEPRECIATION METHODS CHAPTER 16 ENGINEERING ECONOMY Fifth Edition Mc Graw Hill Blank and Tarquin CHAPTER 16 DEPRECIATION METHODS Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16 Preliminary Statement The material presented in this chapter applies to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation. As such, which changing legislation, parts of this chapter could be modified by legislation enacted after publication of this text. Students are encouraged to research the current depreciation rules as they may pertain to the material in this chapter. The IRS web site { www.irs.gov } should be accessed for IRS Publication 946 for the current rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Depreciation – Definition Depreciation is the reduction of an asset’s value over time. Brought on by: Wear and tear, use; Deterioration; Obsolescence. Economic View: Depreciation represents a “ratable” using up of devaluation of a productive asset. The asset must have a finite life span that can be reasonably estimated. Deprecation represents a proper charge against future income produced by the asset in question. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Importance of Depreciation Federal tax law defines the concept of “taxable income” as: Gross Income – Real Cash Expenses – interest – Depreciation amounts. Tax Due = {Taxable Income}(Tax Rate). Taxes and after-tax cash flows are presented in Chapter 17. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Non-Cash Flow Amounts Depreciation and depletion amounts represent “non-cash flow” amounts within an accounting period. Federal and state tax laws recognize various forms of depreciation amounts and depletions amounts to be “tax- deductible amounts,” but are not real cash flows per se. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 After-Tax Cash Flows All “for profit” firms seek to minimize legally their respective income tax liabilities. Depreciation and depletions amounts will lower the taxable income amount and hence the tax liability if claimed. This chapter focuses on the various forms of depreciation and depletion calculations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Types of Depreciation Book Depreciation Tax Depreciation Used by a firm for internal financial and managerial management. Tax Depreciation Used by a firm for state and federal income tax reporting. Follows strict rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Book Depreciation Value of the asset on the firm’s accounting records at any given point in time. Management is free to use any method they so choose to compute book depreciation amounts. Can be any methods such as Straight Line, Declining Balance, Sum-of-the-years digits, or Other. Defines the reduced investment in an asset based upon usage pattern and an assumed life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Tax Depreciation Tax Depreciation: Federal Lever (2001) Must follow current state and federal law pertaining to acceptable methods for computing depreciation for income tax purposes. Federal Lever (2001) MACRS Methods General Depreciation System (GDS). Alternate Depreciation System (ADS). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Book Value of an Asset Book value: Accounting Term, Reflects the undepreciated (value) on the firm’s books at a given point in time. May or may not reflect the true market value of the asset at a point in time. Market value of an asset is what a willing buyer and willing seller agree to consummate a sale or exchange. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: BASIS of an Asset (B) The Basis of an asset is: Purchase cost plus, Delivery costs plus, Installation costs and, Any other costs associated with installing and preparing the asset for use. To be eligible for depreciation, the asset MUST be placed in-service and ready for use. Symbol: B for “Basis” – a dollar amount. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Book Value of an Asset (BVt) The remaining, undepreciated capital investment on the firm’s books after the accumulated amounts of depreciation have been subtracted from the original cost basis. BV’s are usually updated at the end of the firm’s accounting year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Recovery Period - n Recovery Period (in years) is the depreciable life n of the asset in years. Often there are different n values for book and tax depreciation. Both of these values may be different from the asset's estimated productive life. Also known as the Depreciable Life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Market Value (MVt) Market value, a term also used in replacement analysis, is the estimated amount realizable if the asset were sold on the open market. Because of the structure of depreciation laws, the book value and market value may substantially differ. For example, a commercial building tends to increase in market value, but the book value will decrease as depreciation charges are taken, and a computer workstation may have a market value much lower than its book value due to rapidly changing technology. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Salvage Value – S Salvage value is the estimated trade-in or market value at the end of the asset's useful life. It may be positive, zero, or negative due to dismantling and carry-away costs. Salvage values are estimated “up-front” – at the time of the original purchase. As an estimated value, the actual salvage value out at time t = n may or may not reflect the original estimate. Generally speaking, one cannot depreciate an asset below its estimated salvage value. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Depreciation Rate – dt Depreciation rate or recovery rate is the fraction of the first cost removed by depreciation each year. This rate, denoted by dt, may be the same each year, which is called the straight-line rate, or different for each year of the recovery period. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Personal Property Personal property, is the income-producing, tangible possessions of a corporation used to conduct business. Not to be confused with an individual’s personal property like clothes, furniture, etc. Included are most manufacturing and service industry property vehicles, manufacturing equipment, materials handling devices, computers, and networking equipment, telephone equipment office furniture, refining process equipment, and much more. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Real property Real property includes: real estate and all improvements, office buildings, manufacturing structures, test facilities, warehouses, apartments, and other structures. Land itself is considered real property, but it is not depreciable because it has an infinite life – land can never be depreciated for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: The Half-Year Convention During a tax year, assets are purchased and installed throughout the first year. Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year. Under current federal tax law the first year is handled using the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: The Half-Year Convention The 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. This convention is utilized in this text and in most U.S.-approved tax- depreciation methods. There are also mid-quarter and mid-month conventions. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Section “38” Property Often the term “Section 38,” or Section 1238,” is used: Section 1238 (from the IRS Code, Section 1238) is defined as: Tangible personal property (but not buildings or their structural components) that is eligible for depreciation under the federal tax code. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Terminology: Code Section 1250 Property Under the IRS Code, Section 1250 property is “real” property: Buildings and structures eligible for depreciation. Summary: Section 1238 – Personal Property, Section 1250 – Real Property. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Basic (traditional) models are: 16.1 Depreciation Models Basic (traditional) models are: Straight-Line Method (SL), Sum-of-the-Years Digits Method (SYD), Declining Balance Method (DB). Today, the MACRS Method (a form of declining balance-modified). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 History of Depreciation Methods Before 1981 – U.S. code recognized the classical methods. 1981 and after: Classical methods were disallowed for federal tax purposes and replaced with a system termed ACRS – Accelerated Capital Recovery System In 1986 ACRS was replaced with MACRS – Modified Accelerated Capital Recovery System. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Today…. U.S. Federal Corporate Income Taxes must be computed using the MACRS system! States that have corporate income tax laws generally permit all or part of the classical methods to be used for state corporate tax analysis. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Book Value vs. Time: General Case In general, a book value plot will look like: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Book Value Plot for Classical Methods For SL, DB, and MACRS we have: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.1 Accelerate Depreciation SL book values decline in a linear fashion down to a specified salvage value. It writes off the asset in equal amounts over the recovery period. The DB method allows the book value to accelerate faster since the DB plot of book value is below the SL book values. It permits greater depreciation amounts in the early years, and hence reduces the book value faster than the SL method. MACRS also permits accelerated book values, but is not as good as the pure DB method permits. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Must keep up with the changes! IRS Web site: www.irs.gov 16.1 Keeping Up All engineers engaged in the analysis of industrial projects need to be reasonably informed regarding the current Federal Tax law regarding depreciation. The law does change! Must keep up with the changes! IRS Web site: www.irs.gov Check it out for downloadable publications Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.2 Straight-Line: The Standard (SL) SL depreciation is the standard from which all other plans are compared. Assumes the book value declines in a uniform manner down to a specified salvage value – S over n time periods. Assume n years for an asset’s life: The depreciation rate –dt is then: Dt = 1/n Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Notation (to be followed herein) t = the year (t = 1,2, …, n) 16.2 SL Example Notation (to be followed herein) t = the year (t = 1,2, …, n) Dt = Annual depreciation charge, B = The first cost or unadjusted basis, S = Estimated Salvage Value at t = n, n = The Recovery Period, d = The Depreciation Rate = 1/n Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Compute the Basis minus the estimated salvage value and divide by n 16.2 Straight-Line Method Compute the Basis minus the estimated salvage value and divide by n [16.1] [16.2] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.2 SL Example B = $50,000; “n” = 5 years; S = $10,000 at t = 5; Dt for each year is: ($50,000 - $10,000)/5 = $8,000/year Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.2 SL Example: Tabulation Dt BVt 1 $8,000 $42,000 2 8,000 34,000 3 26,000 4 18,000 5 10,000 Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 Declining Balance Method (DB) DB is an accelerated depreciation method; Provides greater depreciation amounts in the early time periods over the SL method. Is more complex that the SL method. Requires assuming a DB rate – normally taken to equal 2 x SL rate. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

The maximum DB rate set by law is: Given the DB rate, Dt for year t is found by multiplying the beginning of time period book value by the rate. The maximum DB rate set by law is: dMAX = 2(1/n), or twice what the straight rate would be. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 DB Equations Depr. For year “t” [16.5] [16.6] Depr. Rate Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

If BV at the end of the preceding year is not known, then apply: 16.3 DB if BVt-1 Not Known If BV at the end of the preceding year is not known, then apply: [16.7] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 DB: Book Value Determination BVt can be determined in two ways: 1. Using the rate d and the basis, B or, 2. Subtracting the current year’s depreciation from the previous year’s book value. BVt from d and B: Apply: [16.8] [16.9] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 DB: Implied Salvage Value Note: From equations 16.4 – 16.9 there is no mention of the salvage value – S! DB does not directly use the estimated salvage value. DB has its own implied salvage value. The pure DB method will never depreciate an asset down to a 0 salvage value unless you solve for a d rate ( Eq. 16.11). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 DB: Implied Salvage Value The implied salvage value built into the DB method is: [16.9] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 Implied SV for DB Depreciation Permissible range for d is: 0 < d < (2/n) To force a prescribed salvage value – S apply: Implied d = 1 – (S/B)1/n [16.11] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

By law, the maximum rate for DB is specified to =: 16.3 DB rate – d By law, the maximum rate for DB is specified to =: Twice the SL rate for a given n. This is called “The Double Declining Balance Rate.” If d = 1.5 (SL rate), it is termed the 150% DB rate. d can never exceed 2(1/n), but can be less! Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.3 Example 16.3 B = $80,000; n = 10 years; S = $10,000; Apply the DB and DDB methods to compute the depreciation amounts and associated BV’s. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

The DB method first computes the implied salvage value from: 16.3 Example 16.3 DB approach The DB method first computes the implied salvage value from: d = 1 – (10,000/80,000)1/10 = 0.1877 d = 18.77% will target the $10,000 SV at t = 10. See Table 16-1 on page 515. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Defines statutory recovery (depreciation) percentages. 16.4 MACRS Method MACRS was derived from the 1981 ACRS system and went into effect in 1986. Defines statutory recovery (depreciation) percentages. Percentages were derived from the DB method with a switch to SL at the optimal time and, Incorporates the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 MACRS Salvage Value The MACRS approach assumes a salvage value of “0” even though that might not be the case! By current law – MACRS assumes all assets depreciated by this method will have a “0” salvage value at the end of the recovery life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 MACRS Actual Depreciation Depreciation for year “t” is: Dt = dt(B) [16.12] dt = a depreciation rate (per cent) applicable for the t-th year. The dt’s are published percentage rates and cannot be changed. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

MACRS book values are determined from: BVt = BVt-1 – Dt [16.13] Or, BVt = Basis – sum of accumulated depreciation. [16.14] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Observations Under MACRS: The entire Basis (B) is fully depreciated (recovered) over a specified number of years (recovery periods). A “0” salvage value is, by law, a functional part of the MACRS system. In reality, there may be a positive, “0”, or negative salvage value at some point in time. Adjustments will have to be made at that time. (Disposal Analysis) Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 MACRS Recovery Periods For Personal Property the following MACRS recovery periods apply: 3- years, 5-years, 7-years, 10-years, 15-years and, 20-years. Six Property Classes for Personal Property – mid-year convention applies. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 MACRS Personal Property Recovery Rates Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Real Property Classes Real Property – buildings, structures, residential rental and non-residential office-factory types: 27.5 years for residential rental property; 39 years for all other properties. Published percentages prorated by months of the year the property is placed in service. Assumes a mid-month convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 39-Year Depreciation Rates Straight-Line Method for n = 39. d = 1/39 = 0.02564 or 2.564% per year; Except in year 1 and in year 40 where technical adjustments are made in the percentages. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

You will see the 6 Recovery Classes and their associated percentages. 16.4 Recovery Lives Examine Table 16-2 on page 518. You will see the 6 Recovery Classes and their associated percentages. Note, for each life category there are n+1 percentage values where n is the class life. Example: In Three-year Recovery period there are 4 recovery percentages! Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Nominal Recovery Periods 3- year property is really recovered over 4 years; 5-year property is really recovered over 6 years; And so forth for each of the other classes. Why is this the case? Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

It does not matter when it is actually placed in-service; 16.4 n+1 Rule The actual recovery of a given class life assumes a half-year convention. That is, it is assumed by law that an asset is placed in-service at the middle of the first year. It does not matter when it is actually placed in-service; So, only a ½ year of recovery is permitted in the first year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

By law, ½ year of recovery is permitted in the first year and, 16.4 n+1 Explained By law, ½ year of recovery is permitted in the first year and, The remaining recovery is spread out over n additional years. See Appendix 16A.3 for more details. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Derivation of the 3-Year MACRS Rates For recovery periods of 3,5,7, and 10 years, the 200% DB with a switch to straight line is imposed. For n = 3, the straight-line rate is 1/3. Twice the straight-line rate is 2(1/3) or 2/3. (0.6667) Assume a basis of $1.00 for simplicity; Let the original basis at time t = 0 = 1.000. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 3-Year analysis: First Year B = 1.000 DDB rate = 0.6667; But only ½ year in year 1 is permitted by law so, d1 = 0.6667/2 = 0.3333; D1 = (0.3333)(1) = 33.33% BV1 = 1 – 0.3333 = 0.6667 remaining at the end of year 1. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

To be recovered over 3 years. Rate for year 2 is (from DDB) BV at the end of year 1: 0.6667B; To be recovered over 3 years. Rate for year 2 is (from DDB) 0.6667(0.6667) = 0.4445 or 44.45% So, d2 = 44.45% and, D2 = 44.45% of B. BV2 = BV1 – D2 = 0.6667B – 0.4445B; BV2 = 0.2222B ( 2 years remaining to recover). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Year 3: Should one switch to SL? BV2 = 0.2222B; SL amount over 2 years would be: 0.2222/2 = 0.1111 for each year; What is the MACRS deduction for year 3 if DDB is applied? d3 = 0.6667(0.2222B) = 0.1481 or 14.81% Which is greater for year 3? 11.11% by switching or, 14.81% by staying with DDB? Ans: Go with the 14.81% …greater than 11.11% Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Take the 14.81% of the Basis for year 3; Book value at the end of year 3 will be BV2 – D3 = 0.2222B - .1481B = 0.0741B. If BV3 = 0.0741B and there is only one more year remaining, then to achieve a “0” salvage value at the end of year 4 we take d4 = 0.0741 – we are done! Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.4 Completed MACRS 3-Year Rates dt BVt 1 0.3333 0.6667B 2 0.4445 0.2222B 3 0.1481 0.0741B 4 0.0741 1.0000 Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.5 MACRS Recovery Periods For book depreciation one should use a life the best reflects the anticipated or expected useful life. For tax depreciation one generally wants as short as possible recovery period to generate more immediate tax savings. For book depreciation use whatever life best defines the usage rate of the asset. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

These breakdowns are termed Property Classes. 16.5 MACRS Recovery Lives For Federal tax purposes, the proper recovery life is found from IRS publications (Pub 946). Table 16-4 illustrated general asset descriptions and their respective MACRS recovery periods permitted by law. These breakdowns are termed Property Classes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.5 The Alternate Depreciation System The IRS offers what is termed the Alternate Depreciation System – ADS. It is a modified form of the MACRS system. Applies a straight-line approach with the half-year convention. Generally used by small or growing firms that do not have sufficient taxable income now and in the immediate future. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.5 ADS: Overview: 5-Year Example ADS applies a form of the straight-line method with the half-year convention. Assume 5-Year Property Class; “n” = 5; 1/n = 0.20 per year except in the first year and in the last year (n=6) Year 1: d1 = ½(0.20) = 0.10 or 10% of B Years 2-5 = 0.20 or 20% of B; Remaining amount – 10% flows over to the last year, t = 6. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.5 ADS: 5-Year Rates Tabulated dt BVt 1 0.10 0.90B 2 0.20 0.70B 3 0.50B 4 0.30B 5 0.10B 6 1.00 Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

ADS provides some relief for firms in this situation. 16.5 ADS: Reason For The ADS is available to smaller firms or firms that are just starting up. Some firms may not be generating sufficient profits to take advantage of the more accelerated depreciation rates that the MACRS-GDS provides. Thus, if GDS is elected, the firm may be losing deductions in the early years. ADS provides some relief for firms in this situation. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

For both the ADS and the GDS: 16.5 ADS: Election For both the ADS and the GDS: For a given tax year the firm elects either the: ADS system for all assets placed in service for the current tax year or, The GDS (accelerated method) for all assets placed in service for the current tax year. The firm cannot mix ADS with GDS within the tax year! (It must be one or the other.) Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

In engineering economy analysis of industrial projects: 16.5 ADS – GDS: In engineering economy analysis of industrial projects: Most analysis will be accomplished using the GDS – accelerated depreciation rates. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Depletion applies to resources that are not easily replaced, like: Depreciation or cost recovery is applied to assets that can be replaced. Depletion applies to resources that are not easily replaced, like: Timber, Mineral deposits, Oil and gas, Etc. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Two Types Cost Depletion Percentage Depletion Called “factor depletion”; Based upon the level of activity or usage; Time is not involved. Percentage Depletion Applies a constant, stated percentage of the resource's gross income provided it does not exceed 50% of the firm’s current taxable income. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Cost Depletion First, the cost basis of the resource is determined – first cost or investment cost. Second, one must estimate the amount of the resource that is available for extraction. Termed: Resource Capacity. It is an estimated value since it is impossible to predict exactly the true resource capacity! Then, cost depletion factor pt for year t is calculated Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Cost Depletion Factor Let t denote the year; pt denotes the depletion factor for year t. Then, pt is defined as: [16.15] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Cost Method Example Example 16.5, page 523 Company buys timber rights to land for $700,000 at time t = 0. Estimated 350 million board feet that can be harvested. This is important: A realistic estimate of the resource must be accomplished up front! Re-estimates can be made in the future and adjustments made. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Important Issue Major Point for Depletion: There must be a reasonable estimate of the amount of the resource that is being extracted. For firms engaged in extraction activities the process of resource estimation is an important activity and requires expert analysis. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Percentage Depletion Percentage depletion uses IRS- mandated percentages for classes of resources. The depletion allowance for this method cannot exceed 50% of the firm’s taxable income before the depletion allowance is claimed. Percent Depletion = Percentage (gross income from activity) Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Percent Method Deposit Percentage Sulfur, uranium, lead, nickel, zinc, 22% Gold, silver, copper, iron ore, and geothermal deposits 15% Oil and gas wells Coal, lignite, sodium chloride 10% Gravel, sand, peat, stone 5% Most other minerals 14% Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 DEPLETION: Percent Method Warning: These percents change over time due to changes in the tax law. If you are involved in extraction industry analysis you must keep up with the current regulations and percents for this method! Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

Gold mine purchased for $10 million. 16.6 DEPLETION See Example 16.6 on page 524. Gold mine purchased for $10 million. Estimated gross income for years 1-5 of $5.0 million and $3.0 million after year 5. Depletion charges cannot exceed 50% of taxable income in any given year (by current tax law). For gold, the rate is 15%/year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 Depletion Law Requirement The depletion allowance can be determined using either the cost or the percentage method. The current law requires: Cost depletion can be used IF the percentage depletion is smaller in any year. This means that one should apply both methods in the beginning. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

16.6 Depletion Law Requirement Calculate both amounts: Cost Depletion ($-Depl) And percentage Depletion (%-Depl) Then apply the following rule each year: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University