Engineering Economic Analysis Chapter 11 Depreciation Donald G. Newnan San Jose State University Ted G. Eschenbach University of Alaska Anchorage Jerome P. Lavelle North Carolina State University Neal A. Lewis University of New Haven Copyright Oxford University Press 2017

Chapter Outline Income, Depreciation, & Cash Flow Basic Aspects of Depreciation Time-Based Depreciation Methods Modified Accelerated Cost Recovery System (MACRS) Depreciation & Asset Disposal Unit-of-Production Depreciation Depletion Spreadsheets & Depreciation Copyright Oxford University Press 2017

Learning Objectives Understand depreciation, deterioration, & obsolescence Understand types of depreciable property Use classic methods to calculate annual depreciation charge & book value Use MACRS to calculate annual depreciation & book value Account for capital gains/losses, ordinary losses, & depreciation recapture due to asset disposal Use unit-of-production & depletion methods Use spreadsheets to calculate depreciation Copyright Oxford University Press 2017

Vignette: Depreciation & Intangible Property Firms depreciate tangible property—forklifts, computers, buildings—as expenses that reduce taxable income Purchased intangible assets can be amortized over time Patents, copyrights, licenses, non-compete agreements Goodwill ≡ firm’s value over value of its assets Intangible property ~80% of total market value of “typical” U.S. firm Nike, Coke, … brands Patent lawsuits between tech firms such as Apple & Samsung Copyright Oxford University Press 2017

Vignette: Depreciation & Intangible Property Other examples of legal battles over intangible assets are _______? If you had to develop a method to amortize a patent, how would you do this? What parameters must you consider? Does % of U.S. firm market value tied to intangible assets surprise you? Why or why not? Is % likely to differ in other countries? Why or why not? Copyright Oxford University Press 2017

Depreciation & Expenses Expenses: subtract from revenues as occur Labor Utilities Materials, etc. Capital: Cannot be expensed all at once Must be expensed over its lifetime Method = depreciation Copyright Oxford University Press 2017

Income Statement Revenue Sales of products & services Total Revenue $184 Costs Cost of Goods Sold Wages, materials, Utilities 110 Depreciation 35 Selling, Admin., Financing 19 Total Costs $164 Net Income Before Taxes 20 Taxes 7 Profit 13 Copyright Oxford University Press 2017

Basic Aspects of Depreciation Definitions Decline in asset’s market value due to deterioration or obsolescence Decline in asset’s value to owner Systematic allocation of asset’s cost over its useful or depreciable life (accountant’s & tax agency’s definition) Copyright Oxford University Press 2017

Depreciation & Expenses Part of regular business operations “Consumed” over short period of time Sometimes recurring Do not lose value gradually over time Subtracted from business revenues as they occur  Reduce taxable income & taxes Examples: labor, utilities, materials, insurance, … Copyright Oxford University Press 2017

Depreciation & Expenses Capital asset costs depreciated over time not expensed as occur Capital assets lose value gradually over time Over depreciable life or recovery period Each year’s depreciation charge reduces taxable income & taxes that year Non-cash accounting entry Examples: buildings, vehicles, machines, … Copyright Oxford University Press 2017

Basic Requirements for Depreciation Property depreciable if: Used for business purposes to produce income Useful life is longer than one year Asset decays, gets used up, wears out, becomes obsolete, or loses value from natural causes Only property owner may claim depreciation expenses Not if: Land, inventory, containers as inventory Leased rather than owned Only business % if business & personal use Copyright Oxford University Press 2017

Types of Property Tangible property: can be seen, touched, & felt Real property: land, buildings, & things growing on, built upon, constructed on, or attached to land Personal property: equipment, furnishings, vehicles, office machinery, tangible items excluding real property Intangible property: cannot be directly seen or touched; examples include patents, copyrights, trademarks—see vignette Copyright Oxford University Press 2017

Depreciation Calculation Fundamentals Book value = Cost basis − Depreciation charges made to date (11-1) Copyright Oxford University Press 2017

Time-based Depreciation Methods Pre-1981 classic methods: Straight-line (SL) Sum-of-the-years’-digits (SOYD) Declining balance (DB) 1981-1986: Accelerated Cost Recovery System (ACRS) Property class lives were created Salvage value was ignored Shorter recovery periods were used 1986-present: Modified ACRS (MACRS) More property classes Half-year convention for first & final years Copyright Oxford University Press 2017

Classic Depreciation Methods Straight-line (SL) 𝑑 𝑡 = 𝐵−𝑆 𝑁 (11-2) Where Dt = depreciation charge in year t B = cost of asset made ready to use S = Salvage value after depreciable life N = Number of years of SOYD = sum of years’ digits = N(N+1)/2 Sum-of-the-years’-digits (SOYD) 𝑑 𝑡 = 𝑁−𝑡+1 𝑆𝑂𝑌𝐷 (11-3) Double declining balance (DDB) 𝑑 𝑡 = 2 𝑁 𝐵𝑉 𝑡−1 = 2 𝑁 (𝐵− 𝑗=1 𝑡−1 𝑑 𝑗 ) (11-4) Copyright Oxford University Press 2017

Depreciation: which is not true? Straight line depreciation used around world Accelerated methods used around world Straight line depreciation used to report annual financial results Most countries allow accelerated methods for determining taxes All of above are true Copyright Oxford University Press 2017

Depreciation: which is not true? Straight line depreciation used around world Accelerated methods used around world Straight line depreciation used to report annual financial results Most countries allow accelerated methods for determining taxes All of above are true Copyright Oxford University Press 2017

Example 11-2 SL Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 Year 900 1 166 734 2 332 568 3 498 402 4 664 236 5 830 70 Copyright Oxford University Press 2017

Example 11-3 SOYD Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 Year $900 1 $277 623 2 221 498 402 3 166 664 236 4 111 775 125 5 55 830 70 Copyright Oxford University Press 2017

Example 11-4 DDB Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 Year 900 1 360 540 2 216 576 324 3 130 706 194 4 78 784 116 5 46 830 70 Copyright Oxford University Press 2017

Advantages of Modified Accelerated Cost Recovery System “Property class lives” < “actual useful lives” MACRS classes based on asset depreciation range (ADR) With ADR, each property class’s life has lower limit, midpoint, & upper limit ADR midpoint lives somewhat < actual average useful lives MACRS property class lives < ADR midpoint lives Salvage value assumed = 0 Tables of annual % simplify computations Copyright Oxford University Press 2017

Modified Accelerated Cost Recovery System (MACRS) General Depreciation System (GDS) Base is declining balance with switch to straight-line Faster depreciation than ADS; tax savings sooner Alternative Depreciation System (ADS) ADS provides a longer recovery period & uses straight-line ADS must be used for Tangible property used primarily outside U.S. Property that is tax exempt or financed by tax-exempt bonds Farming property placed in service when uniform capitalization rules are not applied ADS may be elected for an asset; can’t switch back to GDS Copyright Oxford University Press 2017

Procedures in Applying MACRS Depreciation Determine asset’s cost basis (B) Cost to obtain & place asset in service May include fees & charges Determine property class & recovery period Property class given in problem Asset named in Table 11-1 or -2 or IRS tables Recovery period for that class 7-year for all other property not assigned to class Determine asset’s placed-in-service date Copyright Oxford University Press 2017

Table 11-1 Example Class Lives & MACRS Property Classes IRS Asset Class Asset Description Class Life (Years) ADR MACRS Property Class (years) GDS ADS 00.11 Office furniture, fixtures, & equipment 10 7 00.12 Information Systems: computer/peripheral 6 5 00.22 Automobiles, taxis 3 00.241 Light general-purpose trucks 4 00.25 Railroad cars & locomotives 15 00.40 Industrial steam & electric distribution 22 01.11 Cotton gin assets 12 01.21 Cattle, breeding or dairy 13.00 Offshore drilling assets 7.5 13.30 Petroleum refining assets 16 15.00 Construction assets Copyright Oxford University Press 2017

Table 11-1 Example Class Lives & MACRS Property Classes IRS Asset Class Asset Description Class Life (Years) ADR MACRS Property Class (years) GDS ADS 21.10 Manufacture of grain & grain mill products 17 10 22.2 Manufacture of yarn, thread, & woven fabric 11 7 24.10 Cutting of timber 6 5 32.20 Manufacture of cement 20 15 37.11 Manufacture of motor vehicles 12 48.11 Telephone Communications assets & buildings 24 48.2 Radio & television broadcasting equipment 49.12 Electric utility nuclear production plant 49.13 Electric utility steam production plant 28 49.23 Natural gas production plant 14 50.00 Municipal wastewater treatment plant 80.00 Theme & amusement park assets 12.5 Copyright Oxford University Press 2017

Table 11-2 MACRS GDS Property Classes Personal Property (all property except real estate) 3-Year Property Special handling devices for food & beverage manufacture Special tools for the manufacture of finished plastic products, fabricated metal products, & motor vehicles Property with ADR class life of 4 years or less 5-Year Property Automobiles & trucks (The depreciation for automobiles is limited to $3560 the first tax year, $5700 the second year, $3560 the third year, & 2075 per year in subsequent years.) Aircraft (of non-air-transport companies) Equipment used in research & experimentation Computers Petroleum drilling equipment Property with ADR class life of more than 4 years & less than 10 years 7-Year Property All other property not assigned to another class Office furniture, fixtures, & equipment Property with ADR class life of 10 years or more & less than 16 years Copyright Oxford University Press 2017

Table 11-2 MACRS GDS Property Classes Personal Property (all property except real estate) 10-Year Property Assets used in petroleum refining & certain food products Vessels & water transportation equipment Property with ADR class life of 16 years or more & less than 20 years 15-Year Property Telephone distribution plants Municipal sewage treatment plants Property with ADR class life of 20 years or more & less than 25 years 20-Year Property Municipal sewers Property with ADR class life of 25 years or more Real Property (real estate) 27.5 Year Residential rental property (does not include hotels & motels) 39 Years Nonresidential real property Copyright Oxford University Press 2017

Computer depreciation What is cost recovery period for a computer? 3 years 4 years 5 years Depends on expected life I don’t know Copyright Oxford University Press 2017

Computer depreciation What is cost recovery period for a computer? 3 years 4 years 5 years Depends on expected life I don’t know Copyright Oxford University Press 2017

Procedures in Applying MACRS Depreciation where = depreciation deduction in year t = cost basis being depreciated = appropriate MACRS percentage rate Copyright Oxford University Press 2017

Table 11-3 MACRS GDS Percentage Rate Recovery Year 3-year class 5-year 7-year 10-year class 15-year class 20-year class 1 33.33 20.00 14.29 10.00 5.00 3.750 2 44.45 32.00 24.49 18.00 9.50 7.219 3 *14.81 19.20 17.49 14.40 8.55 6.677 4 7.41 *11.52 12.49 11.52 7.70 6.177 5 *8.93 9.22 6.93 5.713 6 5.76 8.92 7.37 6.23 5.285 7 8.93 *6.55 *5.90 4.888 8 4.46 6.55 5.90 4.522 9 6.56 5.91 *4.462 10 4.461 11 3.28 4.462 12-15 In 15-year 12-15 alternate 5.90 & 5.91 5.9x 16 2.95 17-20 In 20-year 17-20 alternate 4.461 & 4.462 4.46x 21 2.231 * Convert to straight-line Copyright Oxford University Press 2017

Calculation of MACRS GDS Percentages Declining balance start 3-, 5-, 7-, & 10-year classes use 200%; 15- & 20-year classes use 150% declining balance depreciation Convert to straight-line depreciation in optimal year (* in table) Half-year depreciation for first & last years Salvage value assumed = 0 Copyright Oxford University Press 2017

Example 11-5 Calculation of MACRS Percentages Develop 5-year class MACRS % rates. B=100%, S=0, half-year for 1st & last year Year DDB Calculation SL Calculation MACRS Rates Cum. Dep. 1 (½)(2/5)(100%)=20.00% (½)(100%/5)=10.00% 20.00% 2 (2/5)(80.00%) = 32.00% (80.00%/4.5)=17.78% 32.00% 52.00% 3 (2/5)(48.00%) = 19.20% (48.00%/3.5)=13.71% 19.20% 71.20% 4 (2/5)(28.80%) = 11.52% (28.80%/2.5)=11.52% 11.52% 82.72% 5 94.24% 6 (½)11.52%= 5.76% 5.76% 100.00% Copyright Oxford University Press 2017

Example 11-6 Calculation of MACRS Depreciation 7-year property class; B=$150,000; S=$30,000 Year MACRS Calculation Book Value $150,000 1 14.29% ($150,000)(14.29%) $21,435 128,565 2 24.49% (150,000)(24.49%) 36,735 91,830 3 17.49% (150,000)(17.49%) 26,235 65,595 4 12.49% (150,000)(12.49%) 18,735 46,860 5 8.93% (150,000)(8.93%) 13,395 33,465 6 8.92% (150,000)(8.92%) 13,380 20,085 7 6,690 8 4.46% (150,000)(4.46%) Copyright Oxford University Press 2017

Example 11-7 Calculation of MACRS Depreciation (ADS Table 11-4) 39-year property class, B=$20,000,000, purchased in April, disposed 5 years later in August. Year MACRS Calculation Book Value $20,000,000 1 1.819% ($20,000,000)(1.819%) $363,800 19,636,200 2 2.564% (20,000,000)(2.564%) 512,800 19,123,400 3 (20,000,000)(2.564 %) 18,610,600 4 18,097,800 5 17,585,000 6 (20,000,000)(1.605%) 321,000 17,264,000 2,736,000 Copyright Oxford University Press 2017

Example 11-8 Comparison of Depreciation Methods SL SOYD MACRS MACRS DDB Copyright Oxford University Press 2017

Depreciation & Asset Disposal At disposal if asset’s market value differs from book value, the difference is: Depreciation recapture (ordinary gains): asset sold for more than book value, but less than original basis Losses: asset sold for less than book value Capital gains: asset sold for more than original cost basis Rare for depreciated assets Common for stocks, bonds, real estate, art, … Gains may be taxed at lower rate Copyright Oxford University Press 2017

Depreciation & Asset Disposal $4000 Capital Gain $2000 Depreciation Recapture $5000 Depreciation Recapture $3000 Loss Copyright Oxford University Press 2017

Example 11-9 Depreciation & Asset Disposal 3-year property class; B=$10,000; disposed of at 5 years If market value = $7000, the recaptured depreciation = $7000 b) If market value = $0, no recaptured depreciation or loss c) If market value = −$2000, there is a loss of $2000 Copyright Oxford University Press 2017

Example 11-10 Depreciation & Asset Disposal B = $10,000; depreciated using MACRS, 3-yr; Sold during Year 2 for $5000 MV2 = $5000; BV1 = 10,000 – 10,000 x 0.3333 = $6667 50% depreciation claimed in year 2 (IRS rule) D2 = 10,000(r2/2) = 10,000(0.4445/2) = $2222.50 BV2 = BV1 – D2 = 6667 – 2222.50 = $4444.50 Recaptured depreciation = 5000 – 4444.50 = $555.50 Total deduction = 2222.50 – 555.50 = $1667 0% depreciation claimed in year 2 D2 = 0 (easier math hand calc.; same result) Market value – book value = 5000 – 6667 = – 1667 Total deduction = $1667 Copyright Oxford University Press 2017

Example 11-10 Depreciation & Asset Disposal 100% depreciation claimed in year 2 (easier spreadsheet; same result) D2 = 10,000(r2) = 10,000(0.4445) = $4450 BV2 = BV1 – D2 = 6667 – 4450 = $2217 < MV2 Recaptured depreciation = 5000 – 2217 = $2783 Total deduction = 4450 – 2783 = $1667 Copyright Oxford University Press 2017

Unit-of-Production Depreciation When depreciation related to use more than time Copyright Oxford University Press 2017

Example 11-11 Unit-of-Production Depreciation 5-year depreciable life, B=$900K, S=$70K Year Annual Production UOP Depreciation Calculation Book Value $900 1 4,000 (4,000/40,000)(830) $83 817 2 8,000 (8,000/40,000)(830) 166 651 3 16,000 (16,000/40,000)(830) 332 319 4 153 5 83 70 40,000 Copyright Oxford University Press 2017

Depletion Exhaustion of natural resources by removal Depletion allowance is larger of two methods (some exceptions) Cost depletion Similar to unit-of-production depreciation Permissible for standing timber & most oil & gas wells Cost of land must be excluded Percentage Depletion: % of property’s gross income during year Cannot exceed 50% of property’s taxable income without depletion deduction Copyright Oxford University Press 2017

Example 11-12 Cost Depletion Cost of property (timber) = $35,000 Cost of land = $5000 (included in the cost of property) Estimated timber production = 1.5 million board-feet First year’s production = 100,000 board-feet Copyright Oxford University Press 2017

Table 11-6 Percentage Depletion Allowance Type of Deposits Rate Sulfur, uranium, and, if from deposits in U.S., asbestos, lead ore, zinc ore, nickel ore, & mica 22% Gold, silver, copper, iron ore, & certain oil shale, if from U.S. deposits 15% Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone, & carbon dioxide produced from a well 14% Coal, lignite, & sodium chloride 10% Clay & shale used or sold for use in making sewer pipe or bricks or used or sold for use as sintered or burned lightweight aggregates 7½% Clay used or sold for making drainage & roofing tile, flower pots, & kindred products, & gravel, sand, & stone (other than stone used or sold for use by a mine owner or operator as dimension or ornamental stone) 5% Copyright Oxford University Press 2017

Example 11-13 Percentage Depletion Gross income = $250,000 Mining expenses = $210,000 Coal has a 10% depletion allowance Percentage depletion = (10%)($250,000) = $25,000 Taxable income = 250,000 – 210,000 = $40,000 Taxable Income limitation = $40,000(50%) = $20,000 Limitation < percentage depletion; deduction = $20,000 Copyright Oxford University Press 2017

Spreadsheet & Depreciation Technique Excel Function Straight-line SLN(cost, salvage, life) Double-declining balance DDB(cost, salvage, life, period, [factor]) Sum-of-years' digits SYD(cost, salvage, life, period) MACRS VDB(cost, salvage, life, start_period, end_period, [factor], [no_switch]) Copyright Oxford University Press 2017

Using VDB for MACRS =VDB(cost, salvage, life, start_period, end_period, [factor], [no switch]) Excel’s VDB returns depreciation for any period using declining balance with or without straight-line switch Cost is initial basis Salvage is salvage value; use 0 for MACRS Life is recovery period; use 3, 5, 7, 10, 15, or 20 years First period is 0-0.5, second is 0.5-1.5, etc. Factor is declining balance rate; default is 2 = double declining balance No_switch; if TRUE, Excel does not switch to straight-line Copyright Oxford University Press 2017

Using VDB for MACRS Determine 7-year class MACRS depreciation values. B=$150,000, S=$0, half-year for the 1st & last period. Copyright Oxford University Press 2017