Lecture # 8 depreciation ii

Lecture # 8
Cost Estimation
1. Depreciation – part 2
2. Depletion
16-1
Dr. A. Alim

Case Study # 1
 Students will form three teams.
 Each team will work on the following problem:
 AFTER-TAX EVALUATION FOR BUSINESS EXPANSION.
Blank’s Book, 7th ed., Page 482 (end of chapter 17)
 It is helpful to also read section 10.5 in chapter 10 of the book (page 275).
 Answer questions 1 to 4 (Question 4 asks you to determine the AW of EVA)
 Note that the after tax MARR is 10%.

Definition of terms when both debt and equity financing are involved:
1) Debt investment is a loan and is not included in determining the value of P.
This can be readily seen for year zero:
P = CF out - CF in
= Total capital invested – loan amount
= (loan amount + equity investment) – loan amount
= equity investment
2) It is important to know that as a result, the rate of return on capital invested refers
to return on equity investment only. A small equity investment results on a relatively
large rate of return.
3) CFBT = GI – E – equity investment + salvage value – (loan principal + loan interest)
4) Loan interest (but not principal) is tax deductible. Therefore:
TI = GI – E – D – loan interest
5) CFAT = CFBT – TI(te)

Expectations from each team
 The team will work as a group. Each team member must be involved in preparation and
presentation.
 Each team will elect a team leader (I need the team leaders’ names today).
 Each team will make a PowerPoint presentation to the rest of the class and provide me with a
copy of their presentation. Presentations will be on Tuesday, February 18, 2014.
 The presentation will cover:
* Clear definition of the problem, what is given and what is asked
* Theory and basic equations involved.
* Solution strategy.
* Assumptions made and sources of data needed.
* Solution to the problem.
 A list of the students actually presenting must be submitted at
the beginning of each presentation. Students not presenting will not receive a grade for this
project.
 Each team is fully responsible for bringing and testing their lap tops, cables, etc.

Switching between depreciation
methods
Because the DDB method may or may not reach the
estimated salvage value , It is allowed in some countries
and in some US states to switch to SL method near the
end of the recovery period in order to reach the estimated
S, and maximize tax advantage.
In the US, the MACRS method is based on this logic.
Starting with DDB then switching to SL with S value of
zero.
The goal is to maximize the present value of accumulated
depreciation:
PWD = Σ Dt (P/F, i %, t)………for t =1 to n
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012 16-5 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

methods
General rules of switching are summarized here.
1. Switching is recommended when the depreciation for year t
by the currently used model is less than that for a new model.
The selected depreciation Dt is the larger amount.
2. For example, switch to SL if DSL ≥ DDDB
3. Only one switch can take place during the recovery period.
4. The undepreciated amount, that is, BVt is used as the new
adjusted basis to select the larger Di for the next switching
decision.
5. If a value for S is given or assumed, it must be used in
calculating the SL depreciation. The book value at year n can
not be less than S. This makes it ALWAYS advantageous to
switch to SL near or at the last year.

Switching between depreciation methods
Blank, 7th ed. Examples 16A.3 ( p. 433 ) , 16A.4 ( p. 435 )
Blank, 6th ed. Examples 16A.2 ( p. 559 ) , 16A.3 ( p. 562 )
(You may assume S = 0)

Example 16A.3, part (d) is in the homework.

methods (Application)
The MACRS method is based on a switch from DDB to
SL:
• Applying all the rules mentioned earlier
• And allowing for the half year convention
Reading assignment:
Read the following in Blank’s book (7th ed.):
Section 16A.3, page 435. Examples 16A.5 and 16A.6 illustrate
how the MACRS rates are derived by applying DDB-SL switch.

Depletion
 Depreciation is applied to assets that can be
replaced.
 Depletion applies to resources that are not
easily replaced, and are depleted with usage:
 Timber,
 Mineral deposits,
 Oil and gas,
 etc.

Two methods to calculate depletion
 Cost Depletion
 Also called factor depletion
 Based upon the level of activity or usage;
 Time is not involved.
 Percentage Depletion
 Applies a constant, stated percentage of the resource's
gross income provided it does not exceed 50% of the
firm’s current taxable income.

DEPLETION: Cost Depletion
 First, the cost basis of the
resource is determined – first
cost or investment cost.
 Second – one must estimate
the amount of the resource that
is available for extraction.
 Termed: Resource Capacity.
 It is an estimated value
since it is impossible to
predict exactly the true
resource capacity!
 Then, cost depletion factor pt
for year t is calculated …
 If the original resource capacity
is re-estimated in the future, a
new pt is recalculated.
 Let t denote the year
 pt denotes the depletion
factor for year t
 Then, pt is defined as:
 For year “t”: Depletion ($)
= Pt x resource amount
extracted in this yea.
first cost
resource capacity
tp 

DEPLETION: Cost Method
Example
 Example 16.5, page 428, Blank (7th ed.)

DEPLETION: Cost depletion
 Major Point for cost depletion:
 There must be a reasonable estimate
of the amount of the resource that is
being extracted.
 For firms engaged in extraction
activities the process of resource
estimation is an important activity
and requires expert analysis.

Economy, 7th Edition, 2012
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
16-25
Percentage Depletion
• An alternative method for natural resource extraction activities
• A constant stated percentage of the resources gross income may be
depleted each year so long as the calculated depletion amount does
not exceed 50% of the firm’s net taxable income (Defined as GI – E),
i.e. before the depletion deduction is taken !
• Allowable depletions rates are published by the IRS
• THEREFORE: The % depletion allowance is the smaller of the
calculated amount and 50% of the net “taxable income” in the given
year, i.e. 0.5(GI-E)

DEPLETION: Percentage Method
Deposit Percentage
Sulfur, uranium,
lead, nickel , zinc 22%
Gold, silver ,copper,
iron ore and
geothermal deposits
15%
Oil and gas wells
(varies)
15-22%
Coal, lignite, sodium
chloride
10%
Gravel, sand, peat,
stone
5%
Most other minerals 14%
Note:
Due to frequent
revisions of the
US Federal tax
code, the analyst
should always
refer to the latest
published rates!

DEPLETION: Percentage
Method Example
 Example 16.6, page 428, Blank (7th ed.)

Depletion Law Requirement
 The current law:
The law allows taking the larger of the cost
depreciation and the % depreciations in a
given year.
 This means that one should apply both methods in
the beginning, and take the larger depreciation.

Economy, 7th Edition, 2012
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
16-33
CHEE 5369/6369
Homework # 3
Thursday February 6, 2014
The following solved examples from Blank (7th):
Example 16.1 page 418
Example 16.3 page 421
Example 16A.1 page 430
Example 16A.3(d) page 434

Lecture # 8 depreciation ii

More Related Content

What's hot (20)

Viewers also liked (14)

Similar to Lecture # 8 depreciation ii (20)

More from Bich Lien Pham (7)

Recently uploaded (20)

Lecture # 8 depreciation ii