(c) 2001 contemporary engineering economics 1 chapter 10 depreciation asset depreciation factors...

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  • Slide 1
  • (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets
  • Slide 2
  • (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation End of Year Market Value Loss of Value 012345012345 $15,000 10,000 8,000 6,000 5,000 4,000 $5,000 2,000 1,000
  • Slide 3
  • (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income.
  • Slide 4
  • (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time.
  • Slide 5
  • (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an assets value in portions over its depreciable lifeoften used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation
  • Slide 6
  • (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?)
  • Slide 7
  • (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land?
  • Slide 8
  • (c) 2001 Contemporary Engineering Economics 8 Cost Basis Cost of new hole-punching machine (Invoice price) $62,500 + Freight725 + Installation labor2,150 + Site preparation3,500 Cost basis to use in depreciation calculation $68,875
  • Slide 9
  • (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance Old hole-punching machine (book value)$4,000 Less: Trade-in allowance5,000 Unrecognized gains$1,000 Cost of new hole-punching machine$62,500 Less: Unrecognized gains(1,000) Freight725 Installation labor2,150 Site preparation3,500 Cost of machine (cost basis)$67,875
  • Slide 10
  • (c) 2001 Contemporary Engineering Economics 10 Asset Depreciation Range (years) Assets UsedLower LimitMidpoint LifeUpper Limit Office furniture, fixtures, and equipment 81012 Information systems (computers) 567 Airplanes 567 Automobiles, taxis 2.533.5 Buses 7911 Light trucks 345 Heavy trucks (concrete ready-mixer) 567 Railroad cars and locomotives 121518 Tractor units 567 Vessels, barges, tugs, and water transportation system 14.51821.5 Industrial steam and electrical generation and or distribution systems 17.52226.5 Manufacturer of electrical and nonelectrical machinery 81012 Manufacturer of electronic components, products, and systems 567 Manufacturer of motor vehicles 9.51214.5 Telephone distribution plant 283542
  • Slide 11
  • (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation
  • Slide 12
  • (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years Digits Method Unit Production Method
  • Slide 13
  • (c) 2001 Contemporary Engineering Economics 13 Straight Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation D n = (I S) / N, and constant for all n. Book Value B n = I n (D) where I = cost basis S = Salvage value N = depreciable life
  • Slide 14
  • (c) 2001 Contemporary Engineering Economics 14 Example 10.3 Straight-Line Method nD n B n 11,6008,400 21,6006,800 31,6005,200 41,6003,600 51,6002,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n Annual Depreciation Book Value
  • Slide 15
  • (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < < 2(1/N) Note: if is chosen to be the upper bound, = 2(1/N), we call it a 200% DB or double declining balance method.
  • Slide 16
  • (c) 2001 Contemporary Engineering Economics 16 Example 10.4 Declining Balance Method n012345n012345 D n $4,000 2,400 1,440 864 518 B n $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value
  • Slide 17
  • (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 (DDB rate) = (200%) (SL rate) = 0.40 Asset:Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base$10,000 Salvage Value 0 Depreciation200% DB Depreciable life5 years
  • Slide 18
  • (c) 2001 Contemporary Engineering Economics 18 nDepreciation Book Value 1234512345 10,000(0.4) = 4,000 6,000(0.4) = 2,400 3,600(0.4) = 1,440 2,160(0.4) = 864 1,296(0.4) = 518 $6,000 3,600 2,160 1,296 778 n Book Depreciation Value 1234512345 4,000 $6,000 6,000/4 = 1,500 < 2,4003,600 3,600/3 = 1,200 < 1,4402,160 2,160/2 = 1,080 > 8641,080 1,080/1 = 1,080 > 518 0 (a) Without switching(b) With switching to SL Note: Without switching, we have not depreciated the entire cost of the asset and thus have not taken full advantage of depreciations tax deferring benefits. Case 1: S = 0
  • Slide 19
  • (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 End of YearDepreciationBook Value 10.4($10,000) = $4,000$10,000 - $4,000 = $6,000 20.4(6,000) = 2,4006,000 2,400 = 3,600 30.4(3,600) = 1,4403,600 1,440 = 2,160 40.4(2,160) = 864 > 1602,160 160 = 2,000 502,000 0 = 2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.
  • Slide 20
  • (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2
  • Slide 21
  • (c) 2001 Contemporary Engineering Economics 21 Example 10.7 Sum-of-years digits method D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life Annual Depreciation Book Value I = $10,000 N = 5 years S = $2,000 SOYD = 15 n12345n12345 D n (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 B n $7,333 5,200 3,600 2,533 2,000 n
  • Slide 22
  • (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation D n = Service units consumed for year total service units (I - S)
  • Slide 23
  • (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table
  • Slide 24
  • (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value
  • Slide 25
  • (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications Recovery PeriodADR Midpoint ClassApplicable Property 3-yearSpecial tools for manufacture of plastic products, fabricated metal products, and motor vehicles. (ADR =Asset Depreciation Range) 5-yearAutomobiles, light trucks, high-tech equipment, equipment used for R&D, computerized telephone switching systems 7-yearManufacturing equipment, office furniture, fixtures 10-yearVessels, barges, tugs, railroad cars 15-yearWaste-water plants, telephone- distribution plants, or similar utility property. 20-yearMunicipal sewers, electrical power plant. 27.5-yearResidential rental property 39-yearNonresidential real property including elevators and escalators
  • Slide 26
  • (c) 2001 Contemporary Engineering Economics 26 MACRS Table

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