EML4550 2007 1

EML4550 - Engineering Design Methods

Engineering-EconomicsDepreciation & Taxes

Hyman, Chapter 8

EML4550 -- 2007

General Definitions

Market value: The price at which consumers in the open market are willing to pay for a product or service. Generally, market value is less than the value to owner

Book value: an asset value minus the depreciation expense and other liabilities taken to date

Depreciation: the allowance for loss of an asset value due to age, ordinary wear and tear, degraded functionality, etc.. Has a tax-saving consequence as a cost of doing business Taxable income = total income - allowable expenses –

depreciation Depreciation is treated as an expense (tax deductible) An asset can be depreciated over a period of time with

specified amount depending on the nature of the asset.

EML4550 -- 2007

Depreciation

Straight line: one can set aside a fixed depreciation amount of money yearly.

Modified Accelerated Cost Recovery System (MACRS) Economic Recovery Act (1981) ACRS Tax reform Act (1986) MACRS

Special manufacturing devices; some motor vehicles: 3 years Computers; trucks; semiconductor manufacturing equipment: 5

years Office furniture; railroad track; agricultural building: 10 years Sewage treatment plants; telephone systems: 15 years Residential rental property: 27.5 years Nonresidential rental property: 31.5 years

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EML4550 -- 2007

MACRS

The annual depreciation amount is calculated using the recovery rate q given in the table D=qCi

The asset value is completely depreciated even though there may be a true salvage value MACRS assumes the investmentis placed at the midpoint of theinitial year. Therefore, only 50%of the first year depreciation applies for tax purpose. As a result, a half year of depreciation be taken in year n+1

EML4550 -- 2007

Example

An equipment has an initial capital cost of $10,000 and a salvage value of 2,000. The total useful period is 5 years. Compare the annual depreciation amount using either the straight line or the MACRS calculation.

Straight line MACRS

1 1,600 2,000 (0.2)

2 1,600 3,200 (0.32)

3 1,600 1,920 (0.192)

4 1,600 1,150 (0.115)

5 1,600 1,150 (0.115)

6 580 (0.058)

sum 8,000 10,000 (1.0)

EML4550 -- 2007

Taxes

A financial charge by the government on a product, income or activity. Property taxes, sales taxes (by buyers), excise taxes (non-essential goods like

tobacco, liquor), income taxes Corporate federal graduated tax schedule (table 8.10) Only impose on taxable income after deducting operating expenses and depreciation. If there is a state tax, it is usually exempted from federal taxes, therefore,

effective tax rate = state rate + (1- state rate) (federal rate)

Total Income

OperatingExpenses

Depreciation

TaxableIncome Taxes

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Example

A company earns a gross income of $10M. Operating expenses are estimated at $6M and depreciation is $1.5M. (a) Determine the average federal income taxes w/o state taxes; (b) assume the state tax rate is 7%, what is the effective tax rate?

(a) Net income=10 - 6 - 1.5=$2.5M

Taxes=(50,000)(0.15)+(25,000)(0.25)+(25,000)(0.34)+(235,000)(0.39)

+(2,500,000-335,000)(0.34)=7,500

+6,250+8,500+91,650+736,100=$850,000

average tax rate=850,000/2,500,000=0.34

(b) Effective tax rate

= 0.07 + (1 – 0.07)(0.34) = 0.40

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Example

• For motor ADepreciation: 2nd yr - 9.6Tax benefit @0.34- 3.26(-3.26)[P/F] 0.2, 2

=(-3.26)(0.694)=-2.26 this can be deducted as expenses thus decreasing present value of motor A.

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Example (cont.)

• for motor A maint.+electoperating expenses=2.99+9.75=12.74tax benefit @0.34-4.33

Productivity benefit+salv.=-1.5-1.61=-3.11This can be considered income to the company need to pay income taxes @0.34(3.11)(0.34)=1.06• It is positive since we over-estimate the benefit by not considering income taxes previously. We need to add this to the expense category for the motor

EML4550 -- 2007

Inflation

Consumer Price Index (CPI): a composite price index to measure average change over time in the prices paid by urban consumers for a market basket of consumer goods and services such as food, shelter, transportation, apparel, etc.. 1982-1994: 3.33%, 1994-2004: 2.59%

Producer Price Index (PPI): this program measures the average change over time in the selling prices received by domestic producers for their output. Commodity classification

Finished goods (ex. Automobiles, TV) Intermediate materials, supplies (ex. Flour, steel products,

lumber, etc..) Crude materials (ex. Grains, livestock, crude oil, coal, etc..)

Industrial classification Air transportation, power, grocery, etc..

EML4550 -- 2007

Real Discount Rate

Due to annual inflation, the real value (purchasing power) of the money will be decreased accordingly. This reduction can effectively change the real investment rate (interest rate) as:

If we assume the average annual inflation rate is f=0.03, then the nominal interest rate of 20%=0.2 will need to be modified to get the real discount rate

If the inflation rate is small, then ireal inom – f=0.2-0.03=0.17 (about 3% difference w.r.t. 0.165)

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