Taxes and depreciation
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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).

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Review
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
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
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
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 (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
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)


Half year convention

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 Convention


Recall example 1 should we invest
Recall 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%


Example 1 with macrs 3 year

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-year


Economic analysis for macrs 3 year
Economic 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
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
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
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
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 d1
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 d2
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
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
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
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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