Taxes and Depreciation MACRS

Review What is Depreciation? –Decline in value due to wear and tear (deterioration), obsolescence and lower resale value. Why do we compute depreciation? To reduce net profit before taxes =>Decrease taxes =>Increase the cash flow after taxes

Review (cont’d) How do you compute Depreciation? –It is computed separately for each asset. –It depends on » the age of the asset, »the Initial Cost of the asset (P), »the Tax Salvage of the Asset (S) (sometimes), and »the Tax Life of the asset (N)

Depreciation Methods Several depreciation methods exist. So-called historical or classical methods –Straight Line –Sum of the Years Digits –Declining Balance Current method mandated by the government –Modified Accelerated Capital Recovery System (MACRS)

Method 4: Modified Accelerated Capital Recovery System (MACRS) MACRS was created in 1986 and prescribed by the IRS MACRS is now the principal method for computing depreciation. MACRS assigns a class (tax life) to various kinds of property. (Useful life estimates are no longer relevant.) Most tangible personal property fall in one of the six categories: –3-, 5-, 7-, 10-, 15-, 20-year classes Rental property is assigned a 27.5-year tax life Nonresidential real property is assigned a 31.5-year tax life)

MACRS (cont’d) MACRS gives a percentage depreciation for each year. The depreciation is the percentage times the initial cost. MACRS gives organizations the choice of two depreciation systems: General (GDS) or Alternative (ADS). GDS is more accelerated and thus most often preferred.

General Depreciation System (GDS) The GDS percentages are computed with a declining balance method using a switch point. –Double rate for 3-, 5-, 7- and 10-year classes, –1.5 rate for 15- and 20-year classes, –Straight line method for »Rental property (27.5 year life) »Nonresidential real property (31.5 year life)

Half-Year Convention The half-year convention assumes that an asset purchased in a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

Recall Example 1: Should we invest? New Machine: –Investment = $11,000 –Tax Life and Actual Life = 5 years –Tax Salvage and Actual Salvage = $1,000 –Income = $4,000 per year –Operating Expenses = $1,000 per year –40% Tax Rate –After Tax MARR = 9%

Example 1 with MACRS 3-year At the end of period 5, Book Value= 0

Economic Analysis for MACRS 3-year Before-tax NPW = (P/A, 0.09, 5) (P/F, 0.09, 5) = 1319 After-tax NPW = (P/F, 0.09, 1) (P/F, 0.09, 2) + … + ( ) (P/F, 0.09, 5) = 117 Before-tax ROR = 13.34% After-tax ROR = 9.45%

Example 1 with MACRS 5-year At the end of year 5, Book Value = 11, =

Economic Analysis for MACRS 5-year After tax NPW = -110 After tax ROR = 8.61%

Summary Every problem has three kinds of cash flows –Investment: cash flow at time 0 –Annual Revenues /Operating Costs: At times 1 through end of life –Salvage Value: cash flow at end of life

Summary (cont’d) Investment –For new assets, there is no tax effect at time 0.

Summary (cont’d) Annual Revenues / Operating Cost –ATCF = BTCF - Tax –Tax = (BTCF - Depreciation)(tax rate)

Summary (cont’d) Salvage Value –If Book Value (BV) is different than salvage value (SV), there is a tax effect. –Salvage ATCF = Salvage BTCF - Tax –Tax = (SV - BV)(tax rate)

What tax rate do we use? Assume we have a new project with additional income over the current project. What tax rate do we use to find the tax on the additional income? –Use the tax rate that would be applicable to the next dollar of income. This is the incremental tax rate appropriate to your highest level of taxable income

When the asset is actually sold for the price SV, there may be a tax effect. If SV > BV then the amount SV - BV is a capital gain, –you must pay tax on the capital gain If SV < BV then the amount BV - SV is a capital loss, –you may deduct the loss from other capital gains and have tax savings

Conclusions All previous analysis methods described work with tax considerations Use after tax cash flows and after tax MARR for analysis Depreciation of investments is required in analysis The method of depreciation may affect the decision