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 1981 Use book depreciation methods (SL, DB, SOYD) Assets placed in service from 1981 to 1986 Use ACRS (accelerated cost recovery system) table Assets placed in service after 1986 Use 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

3-year

ADR ≤ 4

5-year

7-year 10-year

4 < ADR ≤ 10

10 < ADR ≤ 16 16 < ADR ≤ 20

15-year 20-year

20 < ADR ≤ 25 25 ≤ ADR

Applicable property Special tools for manufacture of plastic products, fabricated metal products, and motor vehicles. Automobiles, light trucks, high-tech equipment, equipment used for R&D, computerized telephone switching systems Manufacturing equipment, office furniture, fixtures Vessels, barges, tugs, railroad cars Waste-water plants, telephone- distribution plants, or similar utility property. Municipal sewers, electrical power plant.

27.5-year

Residential rental property

39-year

Nonresidential real property including elevators and escalators

ADR: Asset depreciation range

MACRS table

MACRS rate calculation Asset cost = $10,000 Property class = 5-year recovery period DB method = half-year convention, zero salvage value, 200% DB switching to SL 20%

32%

19.20% 11.52% 11.52% 5.76%

$2000 $3200 $1920 $1152 $1152 Full

1

Full

Full

2 3 4 Half-year convention

$576

Full

5

6

Year (n)

Calculation in %

MACRS (%)

1

(0.5)(0.40)(100%)

DDB

20%

2

(0.4)(100%-20%) SL = (1/4.5)(80%)

DDB

32% 17.78%

3

(0.4)(100%-52%) SL = (1/3.5)(48%)

DDB

19.20% 13.71%

4

(0.4)(100%-71.20%) switch SL = (1/2.5)(29.80%) to SL

11.52% 11.52%

5

SL = (1/1.5)(17.28%) SL

11.52%

6

SL = (0.5)(11.52%)

5.76%

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 taxes Ex. 8.8- Net income calculation Item

Amount

Gross income (revenue)

$50,000

Expenses Cost of goods sold Depreciation Operating expenses

20,000 4,000 6,000

Taxable income

20,000

Taxes (40%) Net income

8,000 $12,000

Net income: accounting measure of a firm’s after-tax profit

Capital expenditure vs. depreciation expenses

0

$28,000

0

1

2

3

4

5

6

7

8

4

7

6

7

8

capital expenditure (actual cash flow)

1

2

3

$1,250 $4,000

$3,500 $2,500 $2,500 $2,500

$4,900 $6,850 allowed depreciation expenses (not cash flow)

Cash flow vs. net income Net 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 income Cash flow

$1,000,000 1,000,000

$1,000,000 0

Yr 2

Net income Cash flow

1,000,000 1,000,000

1,000,000 2,000,000

Ex. 8.9 – Cash flow vs. net income Item

Income

Cash flow

Gross income (revenue)

$50,000

$50,000

Expenses Cost of goods sold Depreciation Operating expenses

20,000 4,000 6,000

-20,000

Taxable income

20,000

Taxes (40%) Net income Net cash flow

8,000

-6,000 -8,000

$12,000 $16,000

Ex 8.9 (cont.) – Net income versus net cash flow net cash flows = net income + non-cash expense (depreciation)

$50,000 $40,000 $30,000 $20,000 $10,000 $0

net cash flow

net income

$12,000

depreciation

$4,000

income taxes

$8,000

operating expenses

cost of goods sold

$6,000

$20,000

gross revenue

U.S. corporate tax rate (2005) Tax rate Taxable income 0-$50,000 15% $50,001-$75,000 25% $75,001-$100,000 34% $100,001-$335,000 39% $335,001-$10,000,000 34% $10,000,001-$15,000,000 35% $15,000,001-$18,333,333 38% $18,333,334 and Up 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)

(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 income

Marginal tax rate

Amount of taxes

Cumulative taxes

First $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

$ 5 ,5 3 0 ,0 0 0 A v e r a g e ta x r a te = = 3 4 .5 6 % $ 1 6 ,0 0 0 ,0 0 0

Ex. 8.10 - Corporate income taxes Facts: Capital expenditure (allowed depreciation) Gross sales revenue Expenses: Cost of goods sold Depreciation Leasing warehouse Question: Taxable income?

$100,000 $58,000 $1,250,000

$840,000 $58,000 $20,000

Ex. 8.10 - Corporate income taxes (cont.) Taxable income: Gross income Expenses: (cost of goods sold) (depreciation) (leasing expense) Taxable income Income taxes: First $50,000 @ 15% $25,000 @ 25% $25,000 @ 34% $232,000 @ 39% Total taxes

$1,250,000 $840,000 $58,000 $20,000 $332,000

$7,500 $6,250 $8,500 $90,480 $112,730

Average tax rate: Total taxes = Taxable income =

$112,730 $332,000

$112,730 = 33.95% Average tax rate = $332,000

Marginal tax rate: Tax rate that is applied to the last dollar earned 39%

Capital gains & ordinary gains

Capital gains Total gains

Ordinary gains or depreciation recapture

Cost basis

Book value

Salvage value

Ex 8.11 – gains or losses on depreciable asset Drill press: Project year: MACRS: Salvage value:

$230,000 3 yr 7-yr property class $150,000 at the end of yr 3

Full

Full

14.29

24.49 17.49

Half 12.49

8.92

8.92

8.92

Total dep. = 230,000(0.1439 + 0.2449 + 0.1749/2) = $109,308 Book Value = 230,000 - 109,308 = $120,693 Gains = Salvage value – Book value = $150,000 - $120,693 = 29,308 Gains tax (34%) = 0.34 ($29,308) = $9,965 Net proceeds from sale = $150,000 - $9,965 = $140,035

Summary The 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

Depreciable life

Method of depreciation

Book depreciation

Tax depreciation (MACRS)

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.

Firms may select from the following: straight-line, accelerated methods (declining balance, double declining balance, & sumof- 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.