1. MER1601 MER 160 - Design of Thermal Fluid Systems Engineering Economics – Depreciation Methods Professor Bruno Winter Term 2005

2. MER1602 Depreciation Reduction in the value of an asset with time “Book Depreciation:” used by a business to keep track of the value of their assets at any given time “Tax Depreciation:” Used to determine write-offs against income caused by depreciation. MUST BE DONE USING A GOV’T APPROVED METOD

3. MER1603 Concepts of Value Market Value –Price at which property could actually be sold Value to owner –Money amount that would be sufficient to compensate owner if the owner were to be deprived of the property

4. MER1604 Depreciation Terminology Depreciation: reduction in the value of an asset using (government) approved rules D t :depreciation amount B: first cost (installed cost of asset) (Also called the “Unadjusted Basis” or simply “Basis” … hence the “B”) BV t : book value - represents the remaining un- depreciated investment (value) on the books. Determined at the end of the year Note the “t” subscript refers to “time” in years

5. MER1605 Depreciation Terminology n:recovery period (depreciable life of asset in years) d t :depreciation rate (fraction of first cost removed by depreciation in a given year). SV:salvage value (estimated market value at the end of an asset’s useful life).

6. MER1606 Depreciation Terminology Depreciation is allowed for two types of property: Personal Property: income producing tangible possessions of a corporation used to conduct business Real Property: real estate buildings etc (land is not depreciable)

7. MER1607 Methods of Depreciation Accounting (1)Accelerated methods - give a greater write off in the early years (declining balance, MACRS) (2) Uniform Methods - give a uniform write off throughout the entire service life. (straight-line) (3) Decelerated Methods - give a smaller write off in the early years. (sinking fund) CHOICE IS INFLUENCESD BY TAX LAWS

8. MER1608 Straight Line Depreciation D t is the depreciation charge in year t and BV t is the book value at the end of the t th year after the depreciation charge has been made.

9. MER1609 SL Depreciation Example Consider a machine tool with a first cost of $35,000 an estimated life of 20 years and an estimated salvage value of $3,500. Use SL depreciation and calculate the depreciation charge and the book value of the machine tool after 4 years.

10. MER16010 SL Depreciation Example B = $35,000 SV = $3500 n = 20 = 1/20 = 0.05 =0.05*(35000-3500) =$1575 = $35000 – 4($1575) = $28700

11. MER16011 Declining Balance Depreciation Assets are commonly worth more in initial years – it is sensible to write off costs more rapidly in the early years. Declining Balance: a given depreciation rate (d) is applied to the remaining book value each year. i.e. 10% applied to a $35,000 asset 1 st year D t = 0.01*(35000) = 3500 2 nd year D t = 0.10*(35000-3500) = 3150

12. MER16012 Declining Balance Depreciation The maximum allowable percentage is double the straight line rate: (also called Double Declining Balance or DDB method) d max = 2/n The actual depreciation rate is d t = d*(1-d) t-1 D t = d*BV t-1 D t = d*B*(1-d) t-1 BV t = B*(1-d) t With the DB method the BV never goes to zero. However, no asset can be depreciated below the SV!

13. MER16013 DB Depreciation Example Assume that an asset has a first cost of $25,000 and an estimate salvage value of $4000 after 12 years, Calculate its depreciation and book value for (a) year one and (b) year four using the DDB method.

14. MER16014 DB Depreciation Example First Compute the depreciation rate: d = 2/n = 2/12 = 0.1667 (a)For the first year: D 1 = = 0.1667*25000*(1-0.1667) 1-1 =$4167 BV 1 = 25000*(1-.01667) 1 = $20,832.50 Year 4 D = 2411.46, BV = 12,054

15. MER16015 MACRS Economic Reform Act (1981) – ACRS Tax Reform Act (1986) - MACRS Applies to property placed in service after 12/31/86 Doesn’t use useful life or SV Property is organized into ASSET Classes and assigned a Class Life.

16. MER16016 MACRS D t = d t *B (d t is set by the government) BV t = BV t-1 -D t The first cost is always completely depreciated – assumes SV = 0

17. MER16017 MACRS Depreciation Example Calculate the depreciation charge and book value for an asset worth $100,000 using MACRS depreciation with a three year recovery period.