TM 661 Engineering Economics. Depreciation & Taxes. Taxable Income. + Gross Income  Depreciation Allowance  Interest on Borrowed Money  Other Tax Exemptions = Taxable Income. Corporate Tax Rate. Corporate Tax.
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+ Gross Income
 Depreciation Allowance
 Interest on Borrowed Money
 Other Tax Exemptions
= Taxable Income
Ex: Suppose KCorp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the tax paid.
Ex: Suppose KCorp earns $5,000,000 in revenue above manufacturing and operations cost. Suppose further that depreciation costs total $800,000 and interest paid on short and long term debt totals $1,500,000. Compute the after tax cash flow.
Gross Income $ 5,000,000
Depreciation  800,000
Interest  1,500,000
Before Tax Cash Flow $ 2,700,000
Let
P = Initial Cost
n = Useful Life
s = Salvage Value year n
Dt = Depreciation Allowance in year t
Bt = Unrecovered Investment (Book Value) in year t
Then
Dt = (P  S) / n
Bt = P  [ (P  S) / n ]t
Let
P = $100,000
n = 5 years
s = $ 20,000
Then
Dt = (P  S) / n
= $ 16,000
B5 = P  [ (P  S) / n ] 5
= $ 20,000
In declining balance, we write off a constant
% , p, of remaining book value
D1 = pP , P = initial cost
B1 = P  D1 = P  pP
= P(1p)
D2 = pB1
= pP(1p)
In declining balance, we write off a constant
% , p, of remaining book value
B2 = B1  D2 = P(1p)  pB1
= P(1p)  pP(1p)
= P(1p)[1  p]
= P(1p)2
P = $100,000 n = 5 years S = $20,000
p = 2/5 (200% declining balance)
Then
D1 = (2/5)(100,000) = $ 40,000
B1 = 100,000  40,000 = $ 60,000
D2 = (2/5)(60,000) = $ 24,000
D5 = ? , B5 = ?
Ex: Suppose KCorp is interested in purchasing a new conveyor system. The cost of the conveyor is $180,000 and may be depreciated over a 5 year period. KCorp uses 150% declining balance method with a conversion to straight line. Compute the depreciation schedule over the 5 year period.
A $180,000 piece of machinery is installed and is to be depreciated over 5 years. You may assume that the salvage value at the end of 5 years is $ 0. The method of depreciation is to be double declining balance with conversion to straight line using the halfyear convention (you may only deduct 1/2 year of depreciation in year 1). Establish a table showing the depreciation and the end of year book value for each year.
Property Classes
3 yr.  useful life < 4 yrs.
autos, tools
5 yr.  4 yrs. < useful life < 10 yrs.
office epuipment, computers, machinery
7 yr.  10 < UL < 16
office furniture, fixtures, exploration
10 yr.  16 < UL < 20
vessels, tugs, elevators (grain)
15 yr.  20 < UL < 25
data communication, sewers, bridges, fencing
20 yr.  UL > 25
farm buildings, electric generation
27.5  residential rental property
31.5  nonresidential real property
Depreciation
class (3, 5, 7, 10 yr.) uses 200% declining balance switching to straightline @ optimal year
class (15, 20) 150% DB switch to SLD
class (27.5, 31.5) use straightline
Formulas
BTCF = Before Tax Cash Flow
= Revenues  Expenses
TI = Taxable Income
= Cash Flow  Interest  Depreciation
Tax = TI * Tax Rate
ATCF = After Tax Cash Flow
= BTCF  Tax
A company plans to invest in a water purification system (5 year property) requiring $800,000 capital. The system will last 7 years with a salvage of $100,000. The beforetax cash flow for each of years 1 to 6 is $200,000. Regular MACRS depreciation is used; the applicable tax rate is 34%. Construct a table showing each of the following for each of the 7 years.
Ex: A press forming machine is purchased for the manufacture of steel beams for $300,000. The press is considered a 7 year property class (MACRSGDS = 7). Compute the annual depreciation using the MACRS Alternative Depreciation Election.
Soln: MACRS  ADS has a longer life than does MACRS  GDS. In this case 14 years.
Dn = $300,000/14
= $21,428 n = 2, . . ., 14
= $21,428 / 2
= $10,714 n = 1, 15
where
Ut = units produced during the year
U = total units likely to be produced during life
(PF) = depreciable amount allowed
=

t
D
(
P
F
)
t
Q
Operating Day Methodwhere
Qt = total hours used during the year
Q = total hours available during the year
(PF) = depreciable amount allowed
=

t
D
(
P
F
)
t
R
Income Forecast Methodwhere
Rt = rent income earned during the year
R = total likely rent to be earned during life
(PF) = depreciable amount allowed
where
Vt = volume extracted during the year
V = total volume available in reserve
(PF) = depreciable amount allowed
V
=

t
D
(
P
F
)
t
V
Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease. Compute the expected depletion allowance for each year.
Ex:
Allowable Percentages
Oil/Gas 15%
Natural Gas 22%
Sulphur/Uranium 22%
Gold, silver, … 15%
Coal 10%
Ex: NorCo Oil has a 10 year, $27,000,000 lease on a natural gas reservoir in western South Dakota. The reservoir is expected to produce 10 million cubic ft. of gas each year during the period of the lease at $1.50 per cubic ft.
Gross Income = 1.5(10,000,000)
= 15,000,000
Depletion = 15,000,000 (0.22)
= $3,300,000
Shortterm gains $20,000
Shortterm losses  28,500
Net short term loss ($ 8,500)
Long term gains 85,000
Long term losses  19,500
Net long term gain $ 65,500
Net long term gain $ 65,500
Net short term loss ($ 8,500)
Net Capital gain $ 57,000
Net long term gain $ 65,500
Net short term loss ($ 8,500)
Net Capital gain $ 57,000
Taxed as ordinary (35%) $ 19,950
Taxed at capital gain (28%) $ 15,960
KCorp earned $ 750,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.
KCorp earned $ 60,000 as ordinary income and has $100,000 in net capital gain. Compute the tax on the net capital gain.
KCorp earned $ 300,000 as ordinary income and has $100,000 in net capital LOSS. Compute the tax on the net capital gain.
A Net Capital Loss may be carried back up to 3 years or carried forward up to 5 years to offset other net capital gains.
Suppose KCorp had the following NI, Gains, and taxes in the 3 previous years.
1995 1996 1997
Net Income 500,000 700,000 650,000
Capital Gain (80,000) 120,000 50,000
Tax 170,000 238,000 221,000
Gain Tax 0 33,600 14,000
Total Tax 170,000 271,600 235,000
We would carry this year’s net loss back to 1996 to offset net capital gain giving
1995 1996 1997
Net Income 500,000 700,000 650,000
Capital Gain (80,000) 20,000 50,000
Tax 170,000 238,000 221,000
Gain Tax 0 5,600 14,000
Total Tax 170,000 243,600 235,000
Ex: KCorp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. KCorp now sells the loader for $150,000.
Ex: KCorp purchases a Loader for $250,000 which has a 7 year property class life. After 3 years, $140,675 has been depreciated and the book value is now $109,325. KCorp now sells the loader for $150,000.
Recapture = 150,000  109,325
= $40,675
Ex: Suppose KCorp were able to sell this same loader for $ 275,000.
Capital Gain = 275,000  250,000
= $25,000
Depr. Recapture = 250,000  109,325
= $140,675
Ex: Suppose KCorp were able to sell this same loader for $ 275,000.
Capital Gain = 275,000  250,000
= $25,000
Depr. Recapture = 250,000  109,325
= $140,675
$ 25,000 taxed at 28%
$140,675 taxed at 35%
Non residential or commercial real property
If Then
Ft > P Ft  P is section 1231 capital gain
Bt < Ft < P Ft  Bt recaptured as ordinary income
Ft < Bt Bt  Ft is section 1231 loss
Residential or Commercial real property
If Then
Bt < Ft Ft  Bt is section 1231 gain
Ft < Bt Bt  Ft is section 1231 loss
KCorp purchases a CNC machine for $100,000.
ITC = 100,000(0.10) = 10,000
Initial Cost Basis (for depreciation) is reduced 5%
Padj = 100,000(.95) = 95,000