1. 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

2. 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 { } 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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:
Check it out for downloadable publications
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

30. 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

31. 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

32. 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

33. 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

34. 16.2 SL Example: TabulationDt
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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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 ).
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

41. 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

42. 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

43. 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

44. 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

45. The DB method first computes the implied salvage value from:
16.3 Example DB approach
The DB method first computes the implied salvage value from:
d = 1 – (10,000/80,000)1/10 =
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

46. 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

47. 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

48. 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

49. 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

50. 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

51. 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

52. 16.4 MACRS Personal Property Recovery Rates
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

53. 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

54. 16.4 39-Year Depreciation Rates
Straight-Line Method for n = 39.
d = 1/39 = 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

55. 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

56. 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

57. 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

58. 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

59. 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 =
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

60. 16.4 3-Year analysis: First Year
B = 1.000
DDB rate = ;
But only ½ year in year 1 is permitted by law so,
d1 = /2 = ;
D1 = (0.3333)(1) = 33.33%
BV1 = 1 – = remaining at the end of year 1.
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

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

62. 16.4 Year 3: Should one switch to SL?
BV2 = B;
SL amount over 2 years would be:
0.2222/2 = for each year;
What is the MACRS deduction for year 3 if DDB is applied?
d3 = (0.2222B) = 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

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

64. 16.4 Completed MACRS 3-Year Ratesdt
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

65. 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

66. 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

67. 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

68. 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

69. 16.5 ADS: 5-Year Rates Tabulateddt
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

70. 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

71. 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

72. 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

73. 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

74. 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

75. 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

76. 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

77. 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

78. 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

79. 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

80. 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

81. 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

82. 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

83. 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

84. 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