Income, Depreciation & Cash Flow Chapter 11 Mechanical Engineering 431 Engineering Economics

Term 2MECH 431 — Engineering Economics11-2 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.

Term 2MECH 431 — Engineering Economics11-3 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, or investment in, an asset spread over its depreciable life.

Term 2MECH 431 — Engineering Economics11-4 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

Term 2MECH 431 — Engineering Economics11-5 Causes of depreciation ReasonExample Use-related physical loss— deterioration car; light bulb Time-related loss— even if the asset is not used machinery and equipment Functional loss— the asset is unable to meet demand expectations calculators and computers

Term 2MECH 431 — Engineering Economics11-6 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

Term 2MECH 431 — Engineering Economics11-7 Depreciation for tax purposes  Depreciable lifetime— the period over which an asset is depreciated; the capital recovery period  Depreciation is a non-cash expense, i.e. no cash actually flows as capital is recovered. is used to allocate an asset’s loss of value over time. is treated as an expense that is deducted from revenue and thus reduces the taxable income of a business. does generate a cash flow— a reduction in taxes, known as a tax shield.

Term 2MECH 431 — Engineering Economics11-8 Depreciable property  Depreciable property is primarily hard assets that are used for business purposes in the production of income; has a useful lifetime that can be determined, and the useful lifetime is usually longer than one year; decays, is used up, wears out, becomes obsolete, or loses value from natural causes.

Term 2MECH 431 — Engineering Economics11-9 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 Goodwill Brand loyalty, customer loyalty

Term 2MECH 431 — Engineering Economics11-10 Depreciation models  A reliable model of depreciation establishes the value of owned assets accurately and realistically for making decisions; supports planning, e.g. indicates 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.

Term 2MECH 431 — Engineering Economics11-11 General depreciation guidelines  Depreciate an asset as rapidly as is legally possible to derive the largest benefit from 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.

Term 2MECH 431 — Engineering Economics11-12 General depreciation guidelines …  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(depreciation expenses). This value declines as the asset ages.

Term 2MECH 431 — Engineering Economics11-13 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

Term 2MECH 431 — Engineering Economics11-14 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.

Term 2MECH 431 — Engineering Economics11-15 Depreciation methods …  Sum-of-years-digits (SOYD) method: Declining annual depreciation expense, d t. d t = (B – S)(N – t + 1)/SOYD 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.

Term 2MECH 431 — Engineering Economics11-16 Depreciation methods …  Declining balance (DB) method: Constant annual depreciation rate, D. Declining annual depreciation expense, d n. BV n = B(1 – D) n. d n = BD(1 – D) n  1 The constant depreciation rate is applied to a declining depreciation base. The DB method does not account for the full depreciation base (B – S) unless the annual depreciation rate D is set or calculated to force the final book value to S.

Term 2MECH 431 — Engineering Economics11-17 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 required method for corporate business tax purposes and it can provide the greatest present value of depreciation tax shields.

Term 2MECH 431 — Engineering Economics11-18 Depreciation methods …  Unit-of-production (UOP) method: Annual depreciation expenses, d t, 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.

Term 2MECH 431 — Engineering Economics11-19 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 seven years and a salvage value of $15,000. 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 28½% and a discount rate of 12% for straight-line, SOYD and declining balance depreciation. For declining balance, use a rate of 30%, then a custom rate for full depreciation.

Term 2MECH 431 — Engineering Economics11-20 Depreciation methods …

Term 2MECH 431 — Engineering Economics11-21 Depreciation for tax purposes  Corporations in Canada are required to depreciate capital assets by a declining balance 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).

Term 2MECH 431 — Engineering Economics11-22 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.  See the information on the CCA, along with descriptions of CCA classes and rates, at: e.htm#TOP e.htm#TOP

Term 2MECH 431 — Engineering Economics11-23 Depreciation for tax purposes …  Asset class accounting: Assets of a single class are grouped in a single account. Assets may be added to or subtracted from the account each year.  For year t, CCA t = UCC base  d d = CCA rate UCC base is the Undepreciated Capital Cost of the asset class, i.e. the book value or the amount that is eligible for depreciation.

Term 2MECH 431 — Engineering Economics11-24 Depreciation for tax purposes …  CCA allowed in year t = min(CCA t, amount of CCA that would reduce taxable income to 0)  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.

Term 2MECH 431 — Engineering Economics11-25 Depreciation for tax purposes …  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.  CCA 1 = B(d/2) CCA t = Bd(1 – d/2)(1 – d) t  2

Term 2MECH 431 — Engineering Economics11-26 Depreciation for tax purposes …  Example: an asset that cost $250,000 was added to Class 8 (rate = 20%) in 2007, then in 2009, an asset worth $300,000 was added and an asset was salvaged for $80,000. Find the CCAs and UCCs of Class 8 through 2009 if its UCC was $630,000 at the end of 2006.

Term 2MECH 431 — Engineering Economics11-27 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 can 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.

Term 2MECH 431 — Engineering Economics11-28 Depreciation for tax purposes …  Present value of the perpetual CCA tax shields gained on acquiring an asset:

Term 2MECH 431 — Engineering Economics11-29 Depreciation for tax purposes …  Present value (today) of the perpetual CCA tax shields lost on disposing of an asset:

Term 2MECH 431 — Engineering Economics11-30 Depreciation for tax purposes …  By convention, an asset is acquired at the beginning of a year; an asset is sold (salvaged) at the end of a year after we have taken the CCA for the year; the asset’s salvage value is deducted from the UCC of the corresponding asset class; the asset class has other assets and remains open when an asset is sold; and the full CCA can be deducted every year for income tax.

Term 2MECH 431 — Engineering Economics11-31 Depreciation for tax purposes …  The salvage value will no longer be included in the UCC of the asset class.  Thus, the PV of the CCA tax shields that would have been generated by the salvage value must be deducted from the NPV of the project.  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.

Term 2MECH 431 — Engineering Economics11-32 Depreciation for tax purposes …  Note: the pre-disposal UCC is the UCC of the asset class after the CCA has been taken in the year of disposal.  If the disposed 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. Terminal loss = pre-disposal UCC – salvage value The terminal loss produces a tax shield in the year of disposal. The asset class must be closed; i.e. its final UCC is set to zero.

Term 2MECH 431 — Engineering Economics11-33 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. Recaptured depreciation = salvage value – pre-disposal UCC The firm must pay taxes on the recaptured depreciation 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.

Term 2MECH 431 — Engineering Economics11-34 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. 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.

Term 2MECH 431 — Engineering Economics11-35 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 = 30% and MARR = 13% if: (a) other assets remain in the asset classes, and (b) these assets were the only ones in the asset classes.

Term 2MECH 431 — Engineering Economics11-36 Depreciation for tax purposes …

Term 2MECH 431 — Engineering Economics11-37 Natural resources  Depletion: consumption of natural resources. Mineral properties, oil and gas wells, timber.  Federal and provincial governments collect income tax on natural resources.  Depletion calculation methods were discontinued in 1990; existing mines grandfathered.  Percentage depletion: allowance = percent of property’s gross income.  Cost depletion: like unit-of-production depreciation.

Term 2MECH 431 — Engineering Economics11-38 Suggested problems — Chapter 11  11-6, 11-9, 11-21, 11-24, 11-29, 11-35,