Part III: Development of project cash flows

Transcription

1 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

2 Depreciation Definition: loss of value for a fixed asset Example: you purchased a car worth $15,000 in year 0 End of year Market value Loss of value $15,000 10,000 8,000 6,000 5,000 4,000 $5,000 2,000 2,000 1,000 1,000 Depreciation Economic depreciation: Purchase price market value (Economic losses due to both physical deterioration & technological obsolescence)

3 Why do we consider depreciation? Business expense: depreciation is viewed as a part of business expenses that reduce taxable income Gross income expenses: (cost of goods sold) (depreciation) (operating expenses) taxable income income taxes net income (profit) Accounting depreciation: A systematic allocation of the cost basis over a period of time.

4 Asset depreciation: two concepts Economic depreciation the gradual decrease in utility in an asset with use & time Physical depreciation Functional depreciation Depreciation Accounting depreciation the systematic allocation of an asset s value in portions over its depreciable life often used in engineering economic analysis Book depreciation Tax depreciation

5 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 three conditions. Examples?

6 Ex 8.1 Cost basis Cost of a new hole-punching machine (Invoice price) $62,500 + Freight Installation labor 2,150 + Site preparation 3,500 Cost basis to use in depreciation calculation $68,875

7 Cost basis with trade-in allowance Old hole-punching machine (book value) $4,000 Less: Trade-in allowance 5,000 Unrecognized gains $1,000 Cost of a new hole-punching machine $62,500 Less: unrecognized gains (1,000) Freight 725 Installation labor 2,150 Site preparation 3,500 Cost of machine (cost basis) $67,875

8 Factors to consider in asset depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?)

9 Asset depreciation range (years) Assets used Lower Limit Midpoint Life Upper Limit Office furniture, fixtures, and equipment Information systems (computers) Airplanes Automobiles, taxis Buses Light trucks Heavy trucks (concrete ready-mixer) Railroad cars and locomotives Tractor units Vessels, barges, tugs, and water transportation system Industrial steam and electrical generation and or distribution systems Manufacturer of electrical and nonelectrical machinery Manufacturer of electronic components, products, and systems Manufacturer of motor vehicles Telephone distribution plant

10 Book depreciation Types of depreciation In reporting net income to investors/stockholders In pricing decisions Tax depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation Methods of calculating depreciation straight line declining balance unit production

11 Straight-line (SL) method Principle: A fixed asset provides its service in a uniform fashion over its life 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

12 Ex. 8.2 Straight-line method annual depreciation $10,000 $8,000 $6,000 $4,000 $2,000 0 D1 D2 D3 B1 D4 B2 B3 D5 B4 B5 Total depreciation at end of life n book value I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N n D n B n 1 1,600 8, ,600 6, ,600 5, ,600 3, ,600 2,000

13 Declining balance method Principle: A fixed asset provides its service in a decreasing fashion Annual depreciation: Book value: n 1 D α = α(1 α) n = Bn 1 B ) n = ( 1 α where 0 < α < 2(1/N) Note: if α is chosen to be the upper bound, α = 2(1/N), we call it a 200% DB or double declining balance method.

14 Ex. 8.3 Declining balance method I = $10,000 n D n $4,000 2,400 1, B n must be > S B n $10,000 6,000 3,600 2,160 1, N = 5 yr S = $2,000 D n = αb n-1 = αi(1 α) n-1 B n = i(1 α) n n D n $4,000 2,400 1, B n $10,000 6,000 3,600 2,160 2,000 2,000

15 Ex. 8.4 DB switching to SL Asset: Invoice price $9,000 Freight 500 Installation 500 Depreciation base $10,000 Salvage value 0 Depreciation 200% DB Depreciable life 5 years SL depreciation rate = 1/5 = 0.20 DDB rate = (200%) (SL rate) = 0.40 Use whichever method depreciates the asset more, e.g. start with DB & switch to SL Straight line: D n = B n S N n

16 Consider Ex. 8.3 but with S = 0 (a) without switching (b) with switching to SL Book Book n Depreciation value n Depreciation value ,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, ,000 $6,000 6,000/4 = 1,500 < 2,400 3,600 3,600/3 = 1,200 < 1,440 2,160 2,160/2 = 1,080 > 864 1,080 1,080/1 = 1,080 > Note: Without switching, we have not depreciated the entire cost of the asset & thus have not taken full advantage of depreciation s tax deferring benefits.

17 Units-of-production method Principle: service units will be consumed in a non timephased fashion Annual depreciation D n = Service units consumed for year (I - S) total service units

18 Ex 8.5 Units-of-production depreciation Given: I = $55,000 S = $5,000 total service units = 250,000 mi usage for this year = 30,000 mi Solution: 30,000 Dep = ($55,000 $5,000) 250,000 3 = ($50,000) 25 = $6,000