Engineering Economic Analysis Canadian Edition Chapter 11: Income, Depreciation & Cash Flow

11-2 Chapter 11 … Describes depreciation, deterioration, and obsolescence. Distinguishes between types of depreciable property and differentiates depreciation from other expenses. Uses historical methods to calculate annual depreciation expenses and book value. Uses capital cost allowance (CCA) to calculate annual depreciation expenses and book value for assets of various classes. Accounts for capital gains and losses, loss on disposal of fixed assets, and recaptured CCA.

11-3 Basic Aspects of Depreciation Depreciation is an important component in computing income taxes. For tax purposes, depreciation is the systematic allocation of the cost of an asset spread over its depreciable life.

11-4 Depreciation In an economic context: Definition: a decrease in value  Market value  Value to the owner In an accounting context: Definition: a systematic allocation of the cost of an asset over its depreciable life.  Deterioration  Obsolescence

11-5 Causes of Depreciation ReasonExample Use-related physical loss (deterioration) car; light bulb Time-related loss (even if asset is not used) machinery and equipment Functional loss (asset is unable to meet demand expectations) electronic calculators and computers

11-6 Depreciation and Expenses Expenses are subtracted from business revenues as they occur. labour, utilities, materials, insurance, etc. Depreciation is subtracted from business revenues over time as the asset is used up. machinery, installation costs

11-7 Depreciation for Tax Purposes Depreciable life: the period over which an asset is depreciated (recovery period). Depreciation is a non-cash cost: money does not change hands during the recovery period. Depreciation is used to allocate an asset ’ s loss of value over time. Depreciation is deducted from revenue and reduces the taxable income of a business over time. Depreciation therefore gives rise to a cash flow known as a tax shield.

11-8 Depreciable Property Used for business purposes in the production of income. Has a useful life that can be determined, and the useful life is longer than one year. Decays, gets used up, wears out, becomes obsolete or loses value from natural causes.

11-9 Classification of Property Tangible property can be seen, touched, and felt. Real: land, buildings, and things growing on, or attached to the land Personal: equipment, furnishings, vehicles, office machinery, or not defined as real property Intangible property: has value but cannot be seen or touched. Patents, copyrights, and trade marks. Brand loyalty, customer loyalty.

11-10 Depreciation Models A reliable model of depreciation: establishes the accurate value of owned assets to make good managerial decisions; supports planning (e.g., when to keep or sell an asset); determines the cost of current production as accurately as possible; and reflects taxes payable and profits as accurately as possible.

11-11 General Depreciation Guidelines Depreciate an asset as rapidly as is legally possible to derive the largest benefit from offsetting tax shields as early as possible in an asset ’ s life. Depreciation has an indirect effect on cash flows and a direct effect on net income. Initial Capital Cost: total cost of acquiring an asset and putting it into service. This is the cost basis for depreciation of the asset. Book Value = Initial Capital Cost – Σ(Deprec. Expenses). This value declines with age.

11-12 Depreciation Methods Historical methods: Straight line Sum-of-years-digits Declining balance Unit-of-production Tax reporting depreciation methods: Canada: Capital Cost Allowance (CCA) United States: Modified accelerated cost recovery system (MACRS)

11-13 Depreciation Methods … Straight Line (SL) Method: Constant annual depreciation expense (d). d = (B – S)/N; where B = initial capital cost (cost basis), S = salvage value, N = depreciable life. Book value at the end of period t is BV t = B  t  d; where t = 1, 2, … N. Accounts fully for the depreciation base (B  S) during the depreciable lifetime.

11-14 Depreciation Methods … Sum-Of-Years-Digits (SOYD): Declining annual depreciation expenses (d t ). d t = (B  S)(N  t + 1)/SOYD; where SOYD = N(N +1)/2 = … + N. Variable annual rate applied to a constant depreciation base. Accounts fully for the depreciation base (B  S) during the depreciable lifetime. Depreciates an asset more rapidly than the SL method, i.e. larger d t values occur earlier in the asset ’ s life.

11-15 Depreciation Methods … Declining Balance (DB) Method: Constant annual depreciation rate (D). Declining annual depreciation expenses (d n ). d n = DB(1  D) n  1 ; where D = annual depreciation rate. BV n = B(1  D) n. Constant depreciation rate applied to a declining depreciation base DB does not account for the full depreciation base (B  S) unless the annual depreciation rate D is calculated to force the final book value to S.

11-16 Depreciation Methods … The DB method depreciates an asset more rapidly than the SL method, similar to the SOYD method, i.e. larger d n values occur earlier in the asset ’ s life. The DB method may be preferred because it is the “ official ” method used for tax purposes and it can provide the greatest present value of depreciation tax shields.

11-17 Depreciation Methods … Unit-of-Production (UOP) Method: Annual depreciation expenses (d t ) that vary from year to year. d t is more closely related to use of the asset than to time. d t = (Annual production/Lifetime production)(B  S). UOP is appropriate for depreciating assets used in processing natural resources that are exhausted; it is not considered appropriate for depreciating general industrial assets.

11-18 Depreciation Methods … Example: An asset is acquired for $150,000 and it requires $25,000 of capital expenses to put it into service. It is estimated to have a lifetime of five years and a salvage value of $35,000. Find the depreciation expense, book value, and tax shield for each year, then find the present value of the tax shields for a tax rate of 38% and a discount rate of 12% for these methods: straight-line, SOYD and declining balance (use a rate of 30%, then a custom rate for full depreciation).

11-19 Depreciation Methods …

11-20 Depreciation for Tax Purposes Corporations in Canada are required to depreciate capital assets by a DB method known as Capital Cost Allowance (CCA). Companies seek rapid depreciation to maximize tax savings from depreciation. Governments want companies to depreciate assets as slowly as possible to keep tax savings at a minimum. The CCA is a compromise, i.e. it forms part of government ’ s economic policy (give & take).

11-21 Depreciation for Tax Purposes … For calculating CCA, assets are assigned to asset classes that have specified CCA rates. Most asset classes use the declining balance method for computing CCA. Common CCA classes and their rates are listed along with some recent regulatory changes at: pubs/prb0606-e.htm#appendixa. pubs/prb0606-e.htm#appendixa

11-22 Depreciation for Tax Purposes … Asset class accounting: Assets of a single class are grouped in a single ledger account. Assets may be added to or subtracted from the account each year. For year t, CCA t = UCC base  d; where d = CCA rate, and UCC base is the Undepreciated Capital Cost of the asset class that is eligible for depreciation. Maximum CCA for a year = CCA that reduces taxable income to zero.

11-23 Depreciation for Tax Purposes … A maximum of 50% of the initial cost of an asset acquired during a year can be used as the basis for calculating the depreciation in the year of purchase. This is known as the “ 50% rule ”, or sometimes the “ half-year rule ”. For most asset classes, the value of assets disposed of during the year is netted against acquisitions made in the same year. This netting of values mitigates the effect of the 50% rule since it applies to net acquisitions.

11-24 Depreciation for Tax Purposes … CCA 1 = B(d/2) CCA t = Bd(1 – d/2)(1  d) t  2 Example: an asset that cost $250,000 was added to Class 8 (rate = 20%) in 2004, then in 2006, an asset worth $300,000 was added and an asset was salvaged for $80,000. Find the CCAs and UCCs of Class 8 if its UCC was $630,000 at the end of 2003.

11-25 Depreciation for Tax Purposes … The tax shields generated by the CCA generally have an infinite life. But, projects typically have a finite life. When computing NPV, we normally calculate the present value of the operating cash flows separately from the present value of the CCA tax shields. We assume that the acquired asset will be held forever, so we add the present value of the asset ’ s perpetual CCA tax shields to the NPV of the project.

11-26 Depreciation for Tax Purposes … Present value of the perpetual CCA tax shields gained on acquiring an asset:

11-27 Depreciation for Tax Purposes … Present value (today) of the perpetual CCA tax shields lost on disposing of an asset:

11-28 Depreciation for Tax Purposes … By convention, an asset is sold (salvaged) at the end of a year and we have taken the CCA for the year; its salvage value is deducted from the UCC of the corresponding asset class; and the asset class remains open. Since the salvage value will no longer be included in the UCC of the asset class, the present value of the perpetual CCA tax shields from the salvage value must be deducted from the NPV of the project.

11-29 Depreciation for Tax Purposes … Special cases occur when: the salvaged asset is the last one in the class; the salvage value > UCC of the asset class; the salvage value > original cost of the asset. Note: for the following, “ pre-disposal UCC ” means the UCC of the asset class after the CCA has been taken in the year of disposal.

11-30 Depreciation for Tax Purposes … If the asset is the last remaining in the CCA class and salvage value < pre-disposal UCC: deduct the present value of the perpetual CCA tax shields on the pre-disposal UCC from the project NPV. There is a terminal loss (= pre-disposal UCC  salvage value); deducting this loss from income produces a tax shield in the year of disposal. The asset class must be closed and its final UCC must be set to zero.

11-31 Depreciation for Tax Purposes … When the salvage value > pre-disposal UCC (even if the asset class is not closed): deduct the present value of the perpetual CCA tax shields on the pre-disposal UCC from the NPV of the project. There is recaptured depreciation (= salvage value  pre-disposal UCC) on which the firm must pay taxes in the year of disposal. The UCC of the asset class is set to zero. The asset class is closed if this was the last remaining asset; otherwise it stays open.

11-32 Depreciation for Tax Purposes … When the salvage value > original cost of the asset: deduct the present value of the perpetual CCA tax shields on the original cost from the NPV of the project. There is a capital gain (= salvage value  original cost). The firm must pay taxes on ½ of the capital gain in the year of disposal. Subtract the original cost from the UCC of the asset class.

11-33 Depreciation for Tax Purposes … Example: FMI Corporation has purchased: land = $750,000, a building = $545,000 (CCA asset class 1), and manufacturing equipment = $625,000 (CCA asset class 43). Planned lifetime = 12 years. Expected salvage values: land — $1.8 million, building — $325,000, and equipment — $15,000. Find the present value of acquiring and disposing of the assets if FMI ’ s marginal tax rate = 38% and MARR = 13% if: (a) other assets remain in the asset classes, and (b) these assets were the only ones in the asset classes.

11-34 Depreciation for Tax Purposes …

11-35 Natural Resources Depletion: consumption of natural resources. Mineral properties, oil and gas wells, timber. Federal and provincial governments collect income tax on natural resources. Royalties and tax rates vary across the country. Depletion calculation methods were discon- tinued in 1990; existing mines grandfathered. Percentage depletion: allowance = percent of property ’ s gross income. Cost depletion: like unit-of-production depreciation.

11-36 Suggested Problems 11-6, 9, 15, 21, 26, 27, 31, 33.