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# TM 661 Engineering Economics - PowerPoint PPT Presentation

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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### TM 661 Engineering Economics

Depreciation

&

Taxes

+ Gross Income

- Depreciation Allowance

- Interest on Borrowed Money

- Other Tax Exemptions

= Taxable Income

Ex: Suppose K-Corp 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.

+ Gross Income

- Interest

= Before Tax Cash Flow

- Tax

= After Tax Cash Flow

Ex: Suppose K-Corp 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

• Straight Line (SL)

• Sum-of-Years Digits (SYD)

• Declining Balance (DB)

• Prior to 1981

• Accelerated Cost Recovery System (ACRS)

• 1981-86

• Modified Accelerated Cost Recovery (MACRS)

• 1986 on

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(1-p)

D2 = pB1

= pP(1-p)

In declining balance, we write off a constant

% , p, of remaining book value

B2 = B1 - D2 = P(1-p) - pB1

= P(1-p) - pP(1-p)

= P(1-p)[1 - p]

= P(1-p)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 = ?

Time Value of Tax Savings(Tax Rate = 40%)

DDB/SL Conversion(Salvage = \$0)

Ex: Suppose K-Corp 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. K-Corp uses 150% declining balance method with a conversion to straight line. Compute the depreciation schedule over the 5 year period.

DDB/SL Conversion(Half-Year Convention)

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 half-year 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 - non-residential real property

Depreciation

class (3, 5, 7, 10 yr.) uses 200% declining balance switching to straight-line @ optimal year

class (15, 20) 150% DB switch to SLD

class (27.5, 31.5) use straight-line

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 before-tax 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.

• Straight Line with either a half-year or half-month convention.

• Required for property

• outside U.S.

• having tax-exempt status

• financed by tax-exempt bonds

• covered by executive order

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 (MACRS-GDS = 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

• Allows for equal depreciation for each unit of output

where

Ut = units produced during the year

U = total units likely to be produced during life

(P-F) = depreciable amount allowed

=

-

t

D

(

P

F

)

t

Q

Operating Day Method

• Allows for equal depreciation for each unit of output

where

Qt = total hours used during the year

Q = total hours available during the year

(P-F) = depreciable amount allowed

=

-

t

D

(

P

F

)

t

R

Income Forecast Method

• Allows for equal depreciation for each unit of output

where

Rt = rent income earned during the year

R = total likely rent to be earned during life

(P-F) = depreciable amount allowed

• Allows for equal depreciation for each unit of output

where

Vt = volume extracted during the year

V = total volume available in reserve

(P-F) = 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:

• Depletion is taken as a constant percentage of gross income

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

• Compute net long/short term gains or losses

Short-term gains \$20,000

Short-term 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

• Compute net long/short term gains or losses

Net long term gain \$ 65,500

Net short term loss (\$ 8,500)

Net Capital gain \$ 57,000

• Compute net long/short term gains or losses

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

K-Corp earned \$ 750,000 as ordinary income and has \$100,000 in net capital gain. Compute the tax on the net capital gain.

K-Corp earned \$ 60,000 as ordinary income and has \$100,000 in net capital gain. Compute the tax on the net capital gain.

K-Corp 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 K-Corp 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: K-Corp 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. K-Corp now sells the loader for \$150,000.

Ex: K-Corp 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. K-Corp now sells the loader for \$150,000.

Recapture = 150,000 - 109,325

= \$40,675

Ex: Suppose K-Corp 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 K-Corp 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

• Stimulate investment by providing reduced taxation in year in which asset is placed in service.

• On-again, off-again

• Repealed in 1985 with tax rate 46% 35%

K-Corp purchases a CNC machine for \$100,000.

ITC = 100,000(0.10) = 10,000

Initial Cost Basis (for depreciation) is reduced 5%