Beirut Arab University

Faculty of Engineering
Industrial Engineering and Management

Depreciation and Income Taxes

Chapter4
 Objectives

The objective of this Chapter is to explain

how depreciation affects income taxes, and
how income taxes affect economic decision
making.
 Objectives

Income taxes usually represent a significant cash

outflow. In this chapter we describe how after-tax
cash flows result in the after-tax cash flow (ATCF)
procedure.

Depreciation is an important element in finding after-

tax cash flows.
Depreciation: Concept

Depreciation is the decrease in value of physical properties with

the passage of time.

Depreciation is defined as the recovery of capital costs over statutory

recovery periods. This definition is used to compute depreciation for
business assets.

It is an accounting concept, a non-cash cost, that

establishes an annual deduction against before-tax
income.
It is intended to approximate the yearly fraction of an
assets value used in the production of income.
Depreciation: Concept

Business assets can be depreciated only if they meet the following

basic requirements (Property is depreciable) if:

it is used in business or held to produce income.

it has a determinable useful life, longer than one year.
it is something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
it is not inventory, stock in trade, or investment
property.
Depreciation: Concept

The rules for depreciation are linked to the classification of business

property as either tangible or intangible. Depreciable property is

Tangible property can be seen, touched, and felt

- Real Property: includes land, buildings, or all things growing on, built upon,
constructed on, or attached to the land.
- Personal Property: includes equipment, furnishings, vehicles, office
machinery, and anything that is tangible excluding assets defined as real
property

Intangible Property is all property that has value to be owned but cannot
be directly seen or touched (patents, copyrights, trademarks, and
franchise)

depreciated, according to a depreciation schedule, when it is put in

service (when it is ready and available for its specific use).
Depreciation: Book Value

The Book value of an asset is its first cost minus the total
depreciation taken against it to date.
In economic analysis, the only use of book value is to compute
taxes as we will see later.

t
BVt Cost basis - d j
j1

BVt : Book value of the depreciated asset at the end of time t

dj: sum of depreciation deductions taken from 0 to time t.
Depreciation Methods

Depreciation Methods can be categorized as follows:

Pre-1981 methods: include the straight-line, sum of year digits (SYD), and
the declining Balance methods

19881-1986 method: with the Economic Recovery Tax Act (ECRS). The
ACRS method had three key features: (1) property class lives were created
and all depreciated assets assigned to one particular category, (2) the need to
estimate the salvage values was eliminated because all assets were fully
depreciated over their recovery period and (3) shorter recovery periods were
used to calculate annual depreciation.

1986 to present: the modified accelerated cost recovery system (MACRS)

has been in effect sine 1986. the MACRS method is similar to the ACRS
system except that (1) the number of property classes was expanded and (2)
the annual depreciation percentages were modified to include a half-year
convention for the first and final years.
Depreciation Methods: MACRS( GDS or ADS) Recovery Period

The Modified Accelerated Cost Recovery System (MACRS) is

the principle method for computing depreciation for property in
engineering projects.
Applies to most tangible depreciable property placed in service
after December 31, 1986
SVN is defined to be 0 ; useful life estimates are not used directly
in calculating depreciation amounts
 Depreciation Methods: MACRS( GDS or ADS) Recovery Period

Consists of two systems for computing depreciation deductions:

1. The General Depreciation System (GDS)- the main system
2. The Alternative Depreciation System (ADS)
Provides longer recovery period and uses only
straight-line method of depreciation
Assets depreciated under ADS include property
placed in any tax-exempt use and property used
predominantly outside the U.S.
Depreciation Methods: MACRS( GDS or ADS) Recovery Period

When an asset is depreciated using MACRS, the

following information is needed to calculate
deductions.

Cost basis, B
Date the property was placed into service
The property class and recovery period
The MACRS depreciation method (GDS or ADS).
The time convention that applies (half year)
 Depreciation Methods: MACRS( GDS or ADS) Recovery Period

Recovery Period -- Number of years over which basis of

property is recovered through accounting process.
-- Normally the useful life for classical methods
-- Property class for General Depreciation System (GDS)
under MACRS
-- Class Life for Alternative Depreciation System (ADS)
Recovery Rate -- Percentage for each year of MACRS
recovery period used to calculate an annual depreciation
deduction.
 MACRS: GDS- Basic Information

Tangible depreciable property assigned to one of six personal

property classes (3, 5, 7, 10, 15 and 20-year) - Corresponds to GDS
recovery period; personal depreciable property not corresponding to
these periods is considered 7-yr property class.

Real property assigned to two real property classes -- nonresidential

real property and residential rental property.

GDS recovery period is 39 years for nonresidential real property

(31.5 years if in service before May 13, 1993) and 27.5 years for
residential rental property.
 MACRS: ADS- Basic Information

ADS recovery period for tangible personal property is normally

the same as the class life of the property, with some exceptions
( i.e., asset class 00.12 and 00.22 )

Any tangible personal property that does not fit into one of the
asset classes is depreciated using a 12-year ADS recovery period

ADS recovery period for nonresidential real property is 40 years

MACRS: GDS or ADS Recovery Period
 Depreciation Methods: MACRS - GDS

Using MACRS-GDS is easy!

1. Determine the assets recovery period
2. Use the appropriate column that matches the
recovery period to find the recovery rate, rk,
and compute the depreciation for each year as
MACRS: GDS- Half-year convention
 MACRS: GDS or ADS- Half-year convention

HALF-YEAR TIME CONVENTIONS FOR MACRS DEPRECIATION CALCULATIONS

All assets placed in service during the year are treated as if use
began in the middle of the year -1/2- year depreciation is
allowed

If asset is disposed of before the full recovery period is used,

only half of the normal depreciation deduction can be taken for
that year
MACRS : GDS or ADS
 Depreciation Methods: MACRS - GDS

Example1:

Office furniture, costing $10,000 bought on December 21,1992, was

placed in service in January1, 1993, because of installation and delivery
delays. What maximum depreciation may be taken?

a- Use MACRS-GDS half-year convention.

b- Use MACRS-ADS half-year convention
c- Determine the Book value
 Depreciation Methods: MACRS - GDS

Example2:

A firm purchased and placed in service a new piece of semiconductor

manufacturing equipment. The cost basis of the equipment is $100,000.
determine:

a- the depreciation charge permissible in the fourth year.

b- the BV at the end of the fourth year
c- the cumulative depreciation through the third year
d- the BV at the end of the fifth year if the equipment is disposed at that
time.
 Depreciation Methods: MACRS - GDS

Example3:

A large manufacturer of sheet metal products in the Beirut purchased and

placed in service a new, modern, computer-controlled flexible
manufacturing system for $3.0 million.
Using MACRS-ADS system, determine the depreciation deductions that
can be claimed for the new system.
MACRS: GDS- Mid-Month convention
(residential and non-residential real property)
 Depreciation Methods: MACRS - GDS

Example4:

Assadi Group placed in service an apartment building

costing $250,000 on March 15, 2013. what depreciation
amounts can Assadi take for the MACRS recovery period?
 MACRS Disposition

For property depreciated according to the half-year convention,

only half- the depreciation is allowed for the year of
disposition.

Residential rental property and nonresidential real estate use a

midmonth convention. For example, real property sold in
March will take 2.5/12 of that years depreciation.
 Taxes - Income Tax

Income taxes are assessed as a function of gross

revenues minus allowable expenses.
Taxes - Income Tax

Depreciation is not a cash flow, but it affects

a corporations taxable income, and therefore
the taxes a corporation pays.

Taxable income = gross income

all expenses except capital invest.
depreciation deductions.
Tax
MACRS Disposition

The disposal of a depreciable asset can result in a

gain or loss based on the sale price (market value)
and the current book value

A gain is often referred to as depreciation recapture,

and it is generally taxed as the same as ordinary
income.
An asset sold for more than its cost basis results in a
capital gain.
Taxes - Income Tax

Taking taxes into account changes our

expectations of returns on projects, so our MARR
(after-tax) is lower.
Pause and solve

Acme Casting and Molding sold a piece of equipment during

the current tax year for $67,000. This equipment had a cost
basis of $210,000 and the accumulated depreciation was
$153,000. Assume the effective income tax rate is 40%.
Based on this information, what is

a. the gain (loss) on disposal,

b. the tax resulting from this sale, and
c. the tax if the accumulated depreciation was $125,000
instead of $153,000?
 After Tax Cash Flow - ATCF

After-tax economic analysis is generally the same as

before-tax analysis, just using after-tax cash flows
(ATCF) instead of before-tax cash flows (BTCF).

The analysis is conducted using the after-tax MARR.

 After Tax Cash Flow - ATCF

Cash flows are typically determined for each year using

the notation below.

Rk = revenues (and savings) from the project

during period k
Ek = cash outflows during k for deductible
expenses
dk = sum of all noncash, or book, costs
during k, such as depreciation
t = effective income tax rate on ordinary
income
Tk = income tax consequence during year k

ATCFk = ATCF from the project during year k

 After Tax Cash Flow - ATCF

Some important cash flow formulas.

Taxable income

Ordinary income tax consequences

After Tax Cash Flow - ATCF
 After Tax Cash Flow - ATCF

Example 5:

Acme purchased a pump for $250,000 and

expended $20,000 for shipping and
installation. The addition of this pump will
result in an increase in revenue of $80,000,
with associated increased expenses of $10,000,
each year. The pump has a GDS recovery
period of five years, and Acmes effective tax
rate is 41%. What is the ATCF for this project
for the fourth year of service of the asset?
After Tax Cash Flow - ATCF
 After Tax Cash Flow - ATCF

Example 6:

The Lebanese Transportation Company is considering the purchase of 8

new buses to transport BAU students from Beirut to Dubbieh Campus.
Each bus has a capacity of 30 students at an expected value of load
factor of 0.95. A fare of $2 per trip will be charged, and the bus will make
an expected 900 trips per year.
The 8 buses will cost $280,000. Operation and maintenance expenses
will be $250,000 per year.
The transportation Company elects, MACRS-GDS, with half year
convention with a recovery period of 5years.
The buses will be sold for $120,000 at the end of the 5th year. Gain or
Loss at the year of disposal will be considered as ordinary income. The
Lebanese Transportation Company is in the 45% tax bracket. If the
airline uses an after-tax, current dollar rate of 15%, should these buses
be purchased? Use the annual worth method.
 After Tax Cash Flow - ATCF

Depreciation Taxable
year BTCF Rate Depreciation income Income tax ATCF ATCF
0 -280,000 -280,000 -280,000
1 160,400 0.2 56,000 104,400 46,980 113,420 113,420
2 160,400 0.32 89,600 70,800 31,860 128,540 128,540
3 160,400 0.192 53,760 106,640 47,988 112,412 112,412
4 160,400 0.1152 32,256 128,144 57,665 102,735 102,735
5 160,400 0.1152 16,128 144,272 64,922 95,478 175,992.8
5 120,000 87,744 39,485 80,515.20
247,744 NPV 135,972.22
BV 32,256 IRR 33%
Gain or Loss 87,744
Buy the Buses