Engineering

Economics
Depreciation and
After-tax Analysis
2ND Semester A.Y 2019-2020

Engr. Lelie Lou Bacalla

SLSU Part-time Fculty
In light of the recent calamity of the NCoV pandemic, this handout and worksheet will
serve as learning material for students taking up ES219 (Engineering Economy) on the
topic of DECISION UNDER CERTAINTY: DEPRECIATION AND AFTER-TAX
ANALYSIS.

This learning material will have examples and exercises as the students progress
through. The students are advised answer the exercises first before moving on to the next
topic.The students are to answer these exercises with their complete solutions. However,
if the space provided does not suffice, the students are encouraged to use a different
sheet of paper for them to show their complete solution. This material likewise contains
definitions that would simplify explanations. The output from the students will be checked
and recorded.

After this learning material, the students can:

1. Develop decision-making ability in consideration to the different perspective of

economic analysis
2. To calculate income after taxes and depreciation.

Prepared by:

Engr. Lelie Lou B. Bacalla

Instructor
 DEPRECIATION AND AFTER-TAX ANALYSIS

GUIDE QUESTION:
In the previous lessons, we have been assuming that the assets and the
equipment in the problems that we have tackled have constant values, that is, they have
the same value all throughout the years and once they are bought, they are paid
immediately, but apparently, in real world analyses, this is not the case. Assets devaluate
over the years. How do we treat these devaluating assets? Additionally, what if tax plays
a role in the problem?
DEPRECIATION
Depreciation is the method of quantifying how much an asset’s value has been
used up over the years. The value of the expensive asset you bought may be distributed
over a period of time. It is in your discretion as to how many payment periods you are
going to divide this expense, usually, it is its useful life. When this is done, you may pay
off a part of the expensive asset that you have bought.
Assets
An asset is anything that has monetary value. It is can be tangible or intangible.
Tangible assets are those that can be touched, examples are buildings and equipment.
Intangible assets can’t be touched, examples are patents and intellectual property. Both
of these types of assets can be depreciated.
Depreciation schedule
Depreciation schedule is a table that shows how much of the value of your assets
remain.
TYPES OF DEPRECIATION
Straight-line Depreciation
It is the most common way to estimate the devaluation of an asset. It splits the
value of the asset evenly over its useful life. This method is used y small businesses with
simple accounting methods.
STRAIGHT LINE METHOD
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 =
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
 Where:
Initial cost: the amount that you have paid to obtain the asset
Salvage value: the value of the asset at the end of its useful life
Useful lfe: the number of years (or payment periods) that the asset is functional

EXAMPLE 1.

Your company has purchased a new machine with the price of 419,000PhP. At the end
of 28 years, it still has a salvage value of 41,000PhP. Find the depreciation using the
straight-line method.

SOLUTION:
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 =
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒

419,000 − 41,000
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 =
28
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 = 13,500

Therefore, your company will be paying off 13,500PhP per year for 28 years

Double-declining balance Method

The double-declining method is more complicated than the straight-line method. It
pays off the value of the asset twice as quickly compared to the straight-line method. This
method of depreciation is used by businesses that want to recover their money from
investing into an asset as much as possible. For the double-declining method, in the first
year of depreciating an asset, you take away double the amount as would have been in
a straight-line method. In the following years, you apply that rate to the remaining value
of the asset rather than the original cost. To put into symbols, refer to the following formula
and example.
DOUBLE-DECLINING BALANCE METHOD
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 2 𝑥 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑆𝐿 𝑥𝑣𝑎𝑙𝑢𝑒𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑎𝑡 𝑛
Where:
Depreciation rateSL= straight line depreciation rate (1/useful life)
valueof asset at n = value of the asset at any time n

EXAMPLE 2.

Danger Company purchases a machine for $100,000. It has an estimated salvage

value of $10,000 and a useful life of five years. The double declining balance
depreciation calculation is:

SOLUTION

For convenience, let us opt to use a table to keep track:

𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 2 𝑥 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒𝑆𝐿 𝑥𝑣𝑎𝑙𝑢𝑒𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑎𝑡 𝑛

1
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 2 𝑥 𝑥 100,000
5
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 40,000
For the second year:
1
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 2 𝑥 𝑥 60,000
5
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝐷𝐷𝐵 = 24,000

To keep track of the depreciation:

Year Value Depreciation Remaining value

0 100,000 0 100,000
1 100,000 40,000 60,000
2 60,000 24,000 36,000
 3 36,000 14,400 21,600
4 21,600 8,640 12.960
5 12,960 5184 7,776

We stop at year 5 as the equipment has a salvage value of 10,000PhP.

For comparison
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 =
𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
100,000 − 10, 000
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 =
5
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝐿 = 18,000

In straight-line method, you are going to pay equal amounts of 18,000PhP per year for
5 years. However, for double declining method, you pay different amounts per year. By
the third year of payment, you pay less than 18,000PhP. Furthermore, on the last year
of payment, you only pay less than half of the investment.

Sum of Years Method

The sum of year’s method is also a method that also allows you to depreciate your
assets in the earlier years of its useful life. However, the payments are more evenly
distributed compared to the double-declining method.
SUM OF YEARS METHOD
𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒 𝑠𝑝𝑎𝑛 (𝑎𝑠𝑠𝑒𝑡 𝑐𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒)
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝑌𝐷 =
𝑆𝑌𝐷
Where:
SYD: sum of the years

Take the previous problem as an example:

EXAMPLE 3.
 Danger Company purchases a machine for $100,000. It has an estimated salvage
value of $10,000 and a useful life of five years. The sum of years depreciation
calculation is:

SOLUTION:

𝑆𝑌𝐷 = 5 + 4 + 3 + 2 + 1 = 15
For the first year,

5 (100,000 − 10,000)
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝑌𝐷 = = 30,000
15

For the second year:

9 (100,000 − 10,000)
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑆𝑌𝐷 = = 54,000
15
To keep track,

Year Value Depreciation Remaining value

0 100,000 0 100,000
1 100,000 30,000 70,000
2 70,000 24,000 46,000
3 46,000 18,000 28,000
4 28,000 12,000 16,000
5 16,000 6,000 10,000

AFTER-TAX ANALYSIS
After-tax analysis, also called Cas Flow After Taxes (CFAT). In CFAT, aside from
the net cashflow, depreciation and taxes is also taken into account. In this case,
depreciation is used as a “tax shield” as you have acquired it as an asset, it’s value can
be informally used to pay off taxes. In symbols:
 AFTER TAX ANALYSIS
𝐶𝐹𝐴𝑇 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑜𝑡ℎ𝑒𝑟 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 (𝑐𝑎𝑠ℎ 𝑜𝑟 𝑛𝑜𝑛 − 𝑐𝑎𝑠ℎ)

To illustrate this principle, take the example below:

EXAMPLE 4.

A delivery firm has a total operating profit of 2,000,00PhP. It has a depreciation value
of 180,000PhP. It pays 35% to taxes. Calculate the net income of the firm.

SOLUTION:

From the formula given:

𝐶𝐹𝐴𝑇 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑜𝑡ℎ𝑒𝑟 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 (𝑐𝑎𝑠ℎ 𝑜𝑟 𝑛𝑜𝑛 − 𝑐𝑎𝑠ℎ)

Solving for net income:

Income before taxes = profit – depreciation

𝑖𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 = 2,000,000 − 180,000

𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 = 2,000,000 − 180,000
𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥𝑒𝑠 = 1,820,000𝑃ℎ𝑃

Net income = Income before taxes – income before taxes (tax rate)
Net income = Income before taxes (1 – tax rate)
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 1,820,000(1 − 0.35) = 1,183,000𝑃ℎ𝑃

𝐶𝐹𝐴𝑇 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝑜𝑡ℎ𝑒𝑟 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 (𝑐𝑎𝑠ℎ 𝑜𝑟 𝑛𝑜𝑛 − 𝑐𝑎𝑠ℎ)

𝐶𝐹𝐴𝑇 = 1,183,000 + 180,000
𝐶𝐹𝐴𝑇 = 1,363,000𝑃ℎ𝑃
 SELF-PACED LEARNING ACTIVITY
I. DEPRECIATION

Solve each of the following using straight-line method, double-declining and

sum of year methods

1. A company insurance was bought at a price of 300,000PhP. It has a

residual value of 40,000PhP and a useful life of 4 years.
2. A gardening equipment was acquired at 35,000PhP with a useful life 5
years. Assume no salvage value.

II. AFTER-TAX ANALYSIS

Calculate Cash Flow After Tax.

1. A project has a gross revenue of 421,000PhP, an incurred tax cost of

42,000PhP. It has an operating cost of 32,000PhP. Calculate CFAT.
2. An investment was made worth 100,000PhP today. It was invested at 16%
simple interest. In the tenth year, the capital investment of 100,00PhP can
be taken back. Income tax rates at 25%.