Part III: Development of project cash flows
Ch 8: Accounting for depreciation & income taxes– Accounting depreciation– Book depreciation methods– Tax depreciation methods– How to determine “accounting profit”– Corporate taxes
Ch 9: Project cash flow analysis
Ch 10: Handling project uncertainty
Tax depreciation
Purpose: Used to compute income taxes for the IRS
Assets placed in service prior to 1981Use book depreciation methods (SL, DB, SOYD)
Assets placed in service from 1981 to 1986Use ACRS (accelerated cost recovery system) table
Assets placed in service after 1986Use MACRS (modified ACRS) table
Modified accelerated cost recovery systems (MACRS)
Personal property– definition: movable property; property of any kind
except real property – depreciation based on DB method switching to SL– half-year convention (all assets placed in service
mid year)– zero salvage value
Real property– permanent fixtures– SL method– mid-month convention– zero salvage value
MACRS property classifications (IRS publication 534)
Recovery period ADR midpoint class Applicable property
3-year Special tools for manufacture of plastic products, fabricated metal products, and motor vehicles.
5-year Automobiles, light trucks, high-tech equipment, equipment used for R&D, computerized telephone switching systems
7-year Manufacturing equipment, office furniture, fixtures
10-year Vessels, barges, tugs, railroad cars
15-year Waste-water plants, telephone- distribution plants, or similar utility property.
20-year Municipal sewers, electrical power plant.
27.5-year Residential rental property
39-year Nonresidential real property including elevators and escalators
ADR ≤ 4
4 10< ≤ADR
10 16< ≤ADR
16 20< ≤ADR
20 25< ≤ADR
25≤ ADR
ADR: Asset depreciation range
MACRS table
MACRS rate calculation
Asset cost = $10,000Property class = 5-year recovery periodDB method = half-year convention, zero salvage value, 200% DB switching to SL
20%
$2000
32%
$3200
Full
19.20%
$1920
Full
11.52%
$1152
Full
11.52%
$1152
Full
5.76%
$576
1 2 3 4 5 6Half-year convention
Calculation in %
(0.5)(0.40)(100%) 20%
(0.4)(100%-20%) 32%SL = (1/4.5)(80%) 17.78%
(0.4)(100%-52%) 19.20%SL = (1/3.5)(48%) 13.71%
(0.4)(100%-71.20%) switch 11.52%SL = (1/2.5)(29.80%) to SL 11.52%
SL = (1/1.5)(17.28%) 11.52%
SL = (0.5)(11.52%) 5.76%
Year (n)
1
2
3
4
5
6
MACRS (%)
DDB
DDB
DDB
SL
SL
Conventional DB switching to SL
4,000 2,400 1,440 1,080 1,080
MACRS with half-year convention
2,000 3,200 1,920 1,152 1,152 576
MACRS for real property
Types of real property
27.5-year (residential)39-year (commercial)
• SL method• zero salvage value• mid-month convention
Example: Placed a residential property in service in March. Find the depreciation allowance in year 1.
D1 = (9.5/12)(100%/27.5) = 2.879%
Depreciation allowances for a 10-year ownership of the property
Year (n) Calculation Allowed depreciation (%)1 (9.5/12)(100%/27.5) 2.8788%2 100%/27.5 3.6364%3 100%/27.5 3.6364%4 100%/27.5 3.6364%5 100%/27.5 3.6364%6 100%/27.5 3.6364%7 100%/27.5 3.6364%8 100%/27.5 3.6364%9 100%/27.5 3.6364%
10 (11.5/12)(100%/27.5) 3.4848%
Assume that the property will be sold in December of the10th year.
Net income, taxable income & income taxesEx. 8.8- Net income calculation
Item AmountGross income (revenue) $50,000
ExpensesCost of goods soldDepreciationOperating expenses
20,0004,0006,000
Taxable income 20,000
Taxes (40%) 8,000
Net income $12,000
Net income: accounting measure of a firm’s after-tax profit
Capital expenditure vs. depreciation expenses
0 1 2 3 4 5 6 7 8
capital expenditure(actual cash flow)$28,000
0 87673 41 2
$4,000$6,850
$4,900$3,500 $2,500 $2,500 $2,500
$1,250
allowed depreciation expenses (not cash flow)
Cash flow vs. net incomeNet income: An accounting means of measuring a firm’s profitability
based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows & outflows are ignored.
Cash flow: Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, cash flows are more relevant data to use in project evaluation.
Example: Both companies have the same amount of net income & cash sum over 2 years, but company A returns $1 million yearly, while Company B returns $2 million at the end of 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period.
Company A Company B
Yr 1
Net incomeCash flow
$1,000,0001,000,000
$1,000,0000
Yr 2
Net incomeCash flow
1,000,0001,000,000
1,000,0002,000,000
Ex. 8.9 – Cash flow vs. net income
Item Income Cash flow
Gross income (revenue)Expenses
Cost of goods soldDepreciationOperating expenses
Taxable incomeTaxes (40%)Net income $12,000Net cash flow
$50,000 $50,000
20,0004,0006,000
-20,000
-6,00020,000
8,000 -8,000
$16,000
Ex 8.9 (cont.) – Net income versus net cash flow
net cash flows = net income + non-cash expense (depreciation)
$50,000
$8,000
$6,000
$20,000
$0
$40,000
$30,000
$20,000
$10,000
net income
depreciation
income taxes
operating expenses
cost of goods sold
netcash flow $4,000
$12,000
grossrevenue
U.S. corporate tax rate (2005)
Tax rate15%25%34%39%34%35%38%35%
Tax computation$0 + 0.15(D)$7,500 + 0.25 (D)$13,750 + 0.34(D)$22,250 + 0.39 (D)$113,900 + 0.34 (D)$3,400,000 + 0.35 (D)$5,150,000 + 0.38 (D)$6,416,666 + 0.35 (D)
Taxable income0-$50,000$50,001-$75,000$75,001-$100,000$100,001-$335,000$335,001-$10,000,000$10,000,001-$15,000,000$15,000,001-$18,333,333$18,333,334 and Up
(D) denotes the taxable income in excess of the lower bound of each tax bracket
Marginal & effective (average) tax rate for a taxable income of $16,000,000
Taxable incomeMarginal tax
rate Amount of taxes Cumulative taxesFirst $50,000 15% $7,500 $7,500
Next $25,000 25% 6,250 13,750
Next $25,000 34% 8,500 22,250
Next $235,000 39% 91,650 113,900
Next $9,665,000 34% 3,286,100 3,400,000
Next $5,000,000 35% 1,750,000 5,150,000
Remaining $1,000,000
38% 380,000 $5,530,000
A v e ra g e ta x ra te = $ 5 ,5 3 0 ,0 0 0$ 1 6 , ,
.0 0 0 0 0 0
3 4 5 6 %=
Ex. 8.10 - Corporate income taxes
Facts:Capital expenditure $100,000(allowed depreciation) $58,000
Gross sales revenue $1,250,000
Expenses:Cost of goods sold $840,000Depreciation $58,000Leasing warehouse $20,000
Question: Taxable income?
Ex. 8.10 - Corporate income taxes (cont.)
Taxable income:Gross income $1,250,000Expenses:
(cost of goods sold) $840,000(depreciation) $58,000(leasing expense) $20,000
Taxable income $332,000
Income taxes:First $50,000 @ 15% $7,500
$25,000 @ 25% $6,250$25,000 @ 34% $8,500$232,000 @ 39% $90,480
Total taxes $112,730
Average tax rate:
Total taxes = $112,730Taxable income = $332,000
Average tax rate =
Marginal tax rate: Tax rate that is applied to the last dollar earned
39%
$112,730$332,000
= 33.95%
Capital gains & ordinary gains
Cost basis Book value Salvage value
Capital gains
Total gainsOrdinary gains
or depreciation recapture
Ex 8.11 – gains or losses on depreciable asset
Drill press: $230,000Project year: 3 yrMACRS: 7-yr property classSalvage value: $150,000 at the end of yr 3
14.29 24.49 17.49 12.49 8.92 8.92 8.92Full Full Half
Total dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308Book Value = 230,000 - 109,308 = $120,693Gains = Salvage value – Book value = $150,000 - $120,693 = 29,308Gains tax (34%) = 0.34 ($29,308) = $9,965Net proceeds from sale = $150,000 - $9,965 = $140,035
SummaryThe entire cost of replacing a machine cannot be properly
charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service.
The cost charged to operations during a particular year is called depreciation.
From an engineering economics point of view, our primary concern is with accounting depreciation: the systematic allocation of an asset’s value over its depreciable life.
Accounting depreciation can be broken into two categories:Book depreciation – the method of depreciation used for financial
reports & pricing products;Tax depreciation – the method of depreciation used for calculating
taxable income & income taxes; it is governed by tax legislation.
Summary (cont.)The four components of information required to calculate
depreciation are:– cost basis– salvage value– depreciable life – depreciation method
Because it employs accelerated methods of depreciation & shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation.
The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted. It only changes the timing of the payment.
Summary (cont.)
Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation.
Given the frequently changing nature of depreciation & tax law, we must use whatever percentages, depreciable lives, & salvage values mandated at the time an asset is acquired.
Component of depreciation Book depreciation
Tax depreciation (MACRS)
Cost basis
Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc.
Same as for book depreciation
Salvage value
Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations.
Salvage value is zero for all depreciable assets
Component of Depreciation Book depreciation Tax depreciation (MACRS)
Depreciable life
Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs)
Eight recovery periods–3,5,7,10,15,20,27.5,or 39 years–have been established; all depreciable assets fall into one of these eight categories.
Method of depreciation
Firms may select from the following: straight-line, accelerated methods (declining balance, double declining balance, & sum-of- years’ digits
Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight-line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.
Summary (cont.)
Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project.
Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of using depreciation as a means to maximize the value both of engineering projects and of the organization as a whole.
For corporations, the U.S. tax system has the following characteristics:
tax rates are progressive: The more you earn, the more you pay.Tax rates increase in stair-step fashion: four brackets for
corporations and two additional surtax brackets, giving a total of six brackets.
Allowable exemptions and deductions may reduce the overall tax assessment
Summary (cont.)
Marginal tax rate is the rate applied to the last dollar of income earned;
Average (effective) tax rate is the ratio of income tax paid to net income; and
Incremental tax rate is the average rate applied to the incremental income generated by a new investment project.
Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%.
Capital losses are deducted from capital gains; net remaining losses may be carried backward & forward for consideration in years other than the current tax year.
