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### Taxes and Depreciation

MACRS

Review

- What is Depreciation?
- Decline in value due to wear and tear (deterioration), obsolescence and lower resale value.

- Why do we compute depreciation?
- To reduce net profit before taxes =>Decrease taxes =>Increase the cash flow after taxes

Review (cont’d)

- How do you compute Depreciation?
- It is computed separately for each asset.
- It depends on
- the age of the asset,
- the Initial Cost of the asset (P),
- the Tax Salvage of the Asset (S) (sometimes), and
- the Tax Life of the asset (N)

Depreciation Methods

- Several depreciation methods exist.
- So-called historical or classical methods
- Straight Line
- Sum of the Years Digits
- Declining Balance

- Current method mandated by the government
- Modified Accelerated Capital Recovery System (MACRS)

Method 4: Modified Accelerated Capital Recovery System (MACRS)

- MACRS was created in 1986 and prescribed by the IRS
- MACRS is now the principal method for computing depreciation.
- MACRS assigns a class (tax life) to various kinds of property. (Useful life estimates are no longer relevant.)
- Most tangible personal property fall in one of the six categories:
- 3-, 5-, 7-, 10-, 15-, 20-year classes

- Rental property is assigned a 27.5-year tax life
- Nonresidential real property is assigned a 31.5-year tax life)

MACRS (cont’d) (MACRS)

- MACRS gives a percentage depreciation for each year.
- The depreciation is the percentage times the initial cost.
- MACRS gives organizations the choice of two depreciation systems: General (GDS) or Alternative (ADS).
- GDS is more accelerated and thus most often preferred.

General Depreciation System (GDS) (MACRS)

- The GDS percentages are computed with a declining balance method using a switch point.
- Double rate for 3-, 5-, 7- and 10-year classes,
- 1.5 rate for 15- and 20-year classes,
- Straight line method for
- Rental property (27.5 year life)
- Nonresidential real property (31.5 year life)

The half-year convention assumes that an asset purchased in a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

Half-Year ConventionRecall Example 1: Should we invest? a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- New Machine:
- Investment = $11,000
- Tax Life and Actual Life = 5 years
- Tax Salvage and Actual Salvage = $1,000
- Income = $4,000 per year
- Operating Expenses = $1,000 per year
- 40% Tax Rate
- After Tax MARR = 9%

At the end of period 5, Book Value= 0 a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

Example 1 with MACRS 3-yearEconomic Analysis for MACRS 3-year a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Before-tax NPW
= -11000 + 3000 (P/A, 0.09, 5) + 1000 (P/F, 0.09, 5)

= 1319

- After-tax NPW
= -11000 + 3266.52 (P/F, 0.09, 1) + 3755.8 (P/F, 0.09, 2)

+ … + (1800+600) (P/F, 0.09, 5)

= 117

- Before-tax ROR = 13.34%
- After-tax ROR = 9.45%

Example 1 with MACRS 5-year a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- At the end of year 5, Book Value = 11,000 - 2200 - 3520 - 2112 - 1267.2 - 633.6 = 1267.2

Economic Analysis for MACRS 5-year a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- After tax NPW = -110
- After tax ROR = 8.61%

Summary a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Every problem has three kinds of cash flows
- Investment: cash flow at time 0
- Annual Revenues /Operating Costs: At times 1 through end of life
- Salvage Value: cash flow at end of life

Summary (cont’d) a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Investment
- For new assets, there is no tax effect at time 0.

Summary (cont’d) a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Annual Revenues / Operating Cost
- ATCF = BTCF - Tax
- Tax = (BTCF - Depreciation)(tax rate)

Summary (cont’d) a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Salvage Value
- If Book Value (BV) is different than salvage value (SV), there is a tax effect.
- Salvage ATCF = Salvage BTCF - Tax
- Tax = (SV - BV)(tax rate)

What tax rate do we use? a year is purchased in the middle of the year. Therefore, only half a year of depreciation is allowed.

- Assume we have a new project with additional income over the current project.
- What tax rate do we use to find the tax on the additional income?
- Use the tax rate that would be applicable to the next dollar of income.

- This is the incremental tax rate appropriate to your highest level of taxable income

When the asset is actually sold for the price SV, there may be a tax effect.

- If SV > BV then the amount SV - BV is a capital gain,
- you must pay tax on the capital gain

- If SV < BV then the amount BV - SV is a capital loss,
- you may deduct the loss from other capital gains and have tax savings

Conclusions be a tax effect.

- All previous analysis methods described work with tax considerations
- Use after tax cash flows and after tax MARR for analysis
- Depreciation of investments is required in analysis
- The method of depreciation may affect the decision

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