Session Xii Depreciation

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Blank & Tarquin: 5

th
edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University 1
SESSION XII
DEPRECIATION METHODS
ENGINEERING ECONOMY
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University 2
12 Preliminary Statement
The material presented in this chapter
applies to the current (2001) U.S.
Federal Corporate Income Tax Code
relating to depreciation.
As such, which changing legislation,
parts of this chapter could be modified
by legislation enacted after publication
of this text.
12 Preliminary Statement
Students are encouraged to research
the current depreciation rules as they
may pertain to the material in this
chapter.
The IRS web site { www.irs.gov }
should be accessed for IRS Publication
946 for the current rules and
regulations.
Blank & Tarquin: 5
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SESSION XII
Learning Objectives
ENGINEERING ECONOMY
12 Learning Objectives
1. Depreciation Terminology
2. Straight-Line Depreciation
3. Double Declining Balance
Depreciation
4. Modified Accelerated Cost Recovery
System (MACRS)
5. Determining the MACRS Recovery
Period
Blank & Tarquin: 5
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SESSION XII
12.1
DEPRECIATION TERMINOLOGY
ENGINEERING ECONOMY
12.1 Depreciation Definition
Depreciation is the reduction of an
assets value over time.
Brought on by:
Wear and tear, use;
Deterioration;
Obsolescence.
Other definitions follow:

12.1 DepreciationDefinition
Depreciation Original Reason:
Purely economic!
Economic View:
Depreciation represents a ratable using up
of devaluation of a productive asset.
The asset must have a finite life span that
can be reasonably estimated.
Deprecation represents a proper charge
against future income produced by the asset
in question.
12.1 Depreciation and Depletion
Depreciation provides for the
retirement of a productive asset;
Depletion provides for the use of a
natural resource;
Amortization recognizes a prepaid
expense for tax purposes.
12.1 Importance of Depreciation
Federal tax law defines the concept of
taxable income as:
Gross Income Real Cash Expenses
interest Depreciation amounts.
Tax Due =
{Taxable Income}(Tax Rate).
Taxes and after-tax cash flows are
presented in Chapter 17.

12.1 Tax Deductions
Federal Tax law permits the reduction
of Gross Income by a category of
elements termed deductions.
Most deductions are real cash flows:
Wages and salaries;
Cost of materials;
Utilities;
Interest Paid on debt;
State and local taxes paid;
Etc.
12.1 Tax Equation
The General Federal Tax Equation Is:
Tax. Income = Gross Income {Real
Expenses + Interest Paid + Depreciation +
Depletion}
All of the above amounts EXCEPT
depreciation amounts and depletion amounts
are real cash flow to the firm.
12.1 Non-Cash Flow Amounts
Depreciation and depletion amounts
represent non-cash flow amounts
within an accounting period.
Federal and state tax laws recognize
various forms of depreciation amounts
and depletions amounts to be tax-
deductible amounts, but are not real
cash flows per se.
12.1 After-Tax Cash Flows
All for profit firms seek to minimize
legally their respective income tax
liabilities.
Depreciation and depletions amounts
will lower the taxable income amount
and hence the tax liability if claimed.
This chapter focuses on the various
forms of depreciation and depletion
calculations.
12.1 Depreciation Amounts
Federal tax law states that:
Any productive asset with a finite life
(greater than one year) must be depreciated
for tax purposes rather than expensed in
the year of purchase.
Depreciation amounts represent a
prorated amount per year that can be
treated as an expense (deduction),
but is not a real cash flow.

12.1 Tax Savings from Depreciation
Depreciation amounts represent a form
of tax savings to the profitable firm.
Assume a tax rate of, say, 30%.
For every $1 of eligible deductions the
resultant tax savings is:
(0.30)($1.00) = $0.30.
$1 of additional deductions saves the firm
$0.30.
12.1 Simple Example
Consider a basic sewing machine that is
used to sew shoes;
Assume this sewing machine sews
300,000 pairs of shoes, pair by pair.
The sewing machine is losing value
over time due to the use of the machine.
An Economic Concept is at play.
12.1 Simple Example
If the sewing machine costs $2,500 to
begin with, then;
The initial cost of the sewing machine
should be prorated over the 300,000
pairs of shoes.
The initial cost of the sewing machine
is termed the BASIS of the asset.
One can allocate the original basis over
the number of pairs of shoes the
machine produces.
12.1 Types of Depreciation
Book Depreciation
Used by a firm for internal financial and
managerial management.
Tax Depreciation
Used by a firm for state and federal income
tax reporting.
Follows strict rules and regulations.
12.1 Book Depreciation
Value of the asset on the firms
accounting records at any given point in
time.
Used for internal managerial decision
making.
Management is free to use any method
they so choose to compute book
depreciation amounts.
12.1 Book Depreciation
Used internally by the firm;
Be any method:
Straight Line,
Declining Balance;
Sum-of-the-years digits;
Other.
Defines the reduced investment in an
asset based upon usage pattern and an
assumed life.
12.1 Tax Depreciation
Tax Depreciation:
Must follow current state and federal law
pertaining to acceptable methods for
computing depreciation for income tax
purposes.
Federal Lever (2001)
MACRS Methods
General Depreciation System (GDS).
Alternate Depreciation System (ADS).

12.1 Book Value of an Asset
Book value:
Accounting Term,
Reflects the undepreciated (value) on the
firms books at a given point in time.
May or may not reflect the true market
value of the asset at a point in time.
Market value of an asset is what a willing
buyer and willing seller agree to
consummate a sale or exchange.

Blank & Tarquin: 5
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SESSION XII
DEPRECIATION TERMINOLOGY
Important Terms and Their Meanings
ENGINEERING ECONOMY
12.1 Terminology
The following slides state and define
depreciation terminology;
Terminology is very important to the
understanding of this chapter;
Please focus on the terms and their
respective meanings.
12.1 BASIS of an Asset (B)
The Basis of an asset is:
Purchase cost plus,
Delivery costs plus,
Installation costs and,
Any other costs associated with installing
and preparing the asset for use.
To be eligible for depreciation, the asset
MUST be placed in-service and ready for
use.
Symbol: B for Basis a dollar amount.
12.1 Book Value of an Asset (BV
t
)
The remaining, undepreciated capital
investment on the firms books after the
accumulated amounts of depreciation have
been subtracted from the original cost
basis.
BVs are usually updated at the end of the
firms accounting year.
12.1 Recovery Period - n
Recovery Period (in years) is the
depreciable life n of the asset in years.
Often there are different n values for
book and tax depreciation.
Both of these values may be different
from the asset's estimated productive
life.
Also known as the Depreciable Life.
12.1 Market Value (MV
t
)
Market value, a term also used in
replacement analysis, is the estimated
amount realizable if the asset were sold
on the open market.
Because of the structure of
depreciation laws, the book value and
market value may substantially differ.
12.1 Market Value (MV
t
)
For example, a commercial building
tends to increase in market value, but
the book value will decrease as
depreciation charges are taken.
A computer workstation may have a
market value much lower than its book
value due to rapidly changing
technology.

12.1 Salvage Value S
Salvage value is the estimated trade-in
or market value at the end of the asset's
useful life.
The salvage value, S, expressed as an
estimated dollar amount or as a
percentage of the first cost, may be
positive, zero, or negative due to
dismantling and carry-away costs.
12.1 Salvage Value S
Salvage values are estimated up-
front at the time of the original
purchase.
As an estimated value, the actual
salvage value out at time t = n may or
may not reflect the original estimate.
Generally speaking, one cannot
depreciate an asset below its estimated
salvage value.
12.1 Depreciation Rate d
t

Depreciation rate or recovery rate is
the fraction of the first cost removed by
depreciation each year.
This rate, denoted by d
t
, may be the
same each year, which is called the
straight-line rate, or different for each
year of the recovery period.
12.1 Personal Property
Personal property, one of the two types
of property for which depreciation is
allowed, is the income-producing,
tangible possessions of a corporation
used to conduct business.
Not to be confused with an individuals
personal property like clothes, furniture,
etc.

12.1 Personal Property continued
Included are:
most manufacturing and service industry
property vehicles,
manufacturing equipment, materials
handling devices, computers, and
networking equipment,
telephone equipment office furniture,
refining process equipment, and much
more.
12.1 Real property
Real property includes:
real estate and all improvements
office buildings,
manufacturing structures,
test facilities,
warehouses,
apartments, and other structures.
12.1 Real Property
Real property includes real estate and
all improvements office buildings
manufacturing structures, test facilities,
warehouses, apartments, and other
structures.
Land itself is considered real property,
but it is not depreciable because it has
an infinite life land can never be
depreciated for tax purposes.
16.1 The Half-Year Convention
During a tax year, assets are purchased
and installed throughout the first year.
Under past laws, the first year of
depreciation had to be prorated by the
number of months remaining in the tax
year.
Under current federal tax law the first
year is handled using the half-year
convention.
12.1 The Half-Year Convention
The half-year convention assumes that
assets are placed in service or disposed
of in midyear, regardless of when these
events actually occur during the year.
This convention is utilized in this text
and in most U.S.-approved tax-
depreciation methods.
There are also mid-quarter and mid-
month conventions.
12.1 Property Eligible for Depreciation
Real or personal;
Productive assets;
Buildings and structures, but not land.
Used in the pursuit of income
generation;
Have a finite, estimatable life
12.1 Section 38 Property
Often the term Section 38, or Section
1238, is used:
Section 1238 (from the IRS Code,
Section 1238) is defined as:
Tangible personal property (but not
buildings or their structural components)
that is eligible for depreciation under the
federal tax code.
12.1 Code Section 1250 Property
Under the IRS Code, Section 1250
property is real property:
Buildings and structures eligible for
depreciation.
Summary:
Section 1238 Personal Property,
Section 1250 Real Property.
12.1 Depreciation Models
Basic (traditional) models are:
Straight-Line Method (SL),
Sum-of-the-Years Digits Method (SYD),
Declining Balance Method (DB).
Today, the MACRS Method (a form of
declining balance-modified).
12.1 Classical Methods
Classical Methods (supporting Excel
functions) are:
Straight-line,
SYD;
DB.
See Appendix at the end of chapter 16.
12.1 Section 179 Deduction
Section 179 Deduction:
Special provision of the tax code
Benefits the small business
Provides an economic incentive for small
businesses to invest in assets required to
produce a profit
Permits the expensing of up to a certain
amount of investment in depreciable assets
in a given tax year (one-year write-off).
12.1 Section 179 Allowance
The 179 allowance can reduce the
current years income tax liability.
Has a statutory maximum:
For 2001 max. amount = $24,000
For 2003 increases to $25,000.
If more than $200,000 is invested in a
given year, the 179 amount is reduced
dollar for dollar.
16.1 History
Before 1981 U.S. code recognized the
classical methods.
1981 and after:
Classical methods were disallowed for
federal tax purposes and replaced with a
system termed ACRS Accelerated Capital
Recovery System
In 1986 ACRS was replaced with MACRS
Modified Accelerated Capital Recovery
System.
12.1 Today.
U.S. Federal Corporate Income Taxes
must be computed using the MACRS
system!
States that have corporate income tax
laws generally permit all or part of the
classical methods to be used for state
corporate tax analysis.
12.1 Comparison of Methods
It is beneficial to compare:
Straight-line,
SYD, and
DB methods.
The best way is to plot the book values
of each method vs. the recovery period
(time).
See Figure 16.1 on page 510.
12.1 Book Value vs. Time: General Case
In general, a book value plot will look
like:
16.1 Book Value Plot for Classical Methods
For SL, DB, and MACRS we have:
12.1 Accelerate Depreciation
From Figure 16-1 on page 510:
SL book values decline in a linear fashion
down to a specified salvage value.
The DB method allows the book value to
accelerate faster since the DB plot of book
value is below the SL book values.
MACRS also permits accelerated book
values, but is not as good as the pure DB
method permits.
12.1 Accelerating Depreciation
The SL methods writes off the asset in
equal amounts over the recovery period.
The DB method permits greater
depreciation amounts in the early years,
and hence reduces the book value faster
than the SL method.
Likewise for the MACRS method!
12.1 Accelerating Depreciation
More depreciation in the early years
means more tax savings sooner.
Assumes a profitable firm.
Tax savings early in the life of an asset
has a greater present value that tax
savings out in time.
Larger depreciation amounts early on
result in increased PW of future tax
savings to the firm.
12.1 What Does It Mean?
If the firm is profitable, then more
depreciation amounts in the early years
means:
Lower tax liability;
Pay less taxes more $$ available for
reinvestment!
The firm can retain more after-tax funds if
the depreciation is accelerated in the early
years of an assets life.
Thus, more depreciation $$ early on are
better!
12.1 Keeping Up
All engineers engaged in the analysis of
industrial projects need to be
reasonably informed regarding the
current Federal Tax law regarding
depreciation.
The law does change!
Must keep up with the changes!
IRS Web site: www.irs.gov
Check it out for downloadable publications
Blank & Tarquin: 5
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SESSION XII
12.2
STRAIGHT-LINE (SL)
DEPRECIATION
ENGINEERING ECONOMY
12.2 Straight-Line: The Standard (SL)
SL depreciation is the standard from
which all other plans are compared.
Assumes the book value declines in a
uniform manner down to a specified
salvage value S over n time periods.
Assume n years for an assets life:
The depreciation rate d
t
is then:
D
t
= 1/n
12.2 SL Example
Notation (to be followed herein)
t = the year (t = 1,2, , n)
D
t
= Annual depreciation charge,
B = The first cost or unadjusted basis,
S = Estimated Salvage Value at t = n,
n = The Recovery Period,
d = The Depreciation Rate = 1/n
12.2 Straight-Line Method
Compute the Basis minus the estimated
salvage value and divide by n
( )
t
t
D B S d
B S
D
n
=
=
[16.1]
[16.2]
12.2 SL Excel Function
In Excel the built-in function is:
SLN(B,S,n)
Displays the annual depreciation D
t
as a
single cell operation.
12.2 SL Example
B = $50,000;
n = 5 years;
S = $10,000 at t = 5;
D
t
for each year is:
($50,000 - $10,000)/5 = $8,000/year
12.2 SL Example: Tabulation
t D
t
BV
t

1 $8,000 $42,000
2 8,000 34,000
3 8,000 26,000
4 8,000 18,000
5 8,000 10,000
12.2 Plot of the Straight-Line Book Value
12.2 SL Observations
The SL method starts at B and directly
targets S n time periods from the
present.
The Depreciation amounts are all equal
($8,000 in this case).
The book values decline at the same
rate down to $10,000.
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SESSION XII
12.3
DECLINING BALANCE AND DOUBLE
DECLINING BALANCE
DEPRECIATION

M
c

Graw
Hill
ENGINEERING ECONOMY Fifth Edition
Blank and Tarquin
12.3 Declining Balance Method (DB)
DB is an accelerated depreciation
method;
Provides greater depreciation amounts
in the early time periods over the SL
method.
Is more complex that the SL method.
Requires assuming a DB rate
normally taken to equal 2 x SL rate.
12.3 DB Rate
Given the DB rate,
D
t
for year t is found by multiplying the
beginning of time period book value by the
rate.
The maximum DB rate set by law is:
d
MAX
= 2(1/n), or twice what the straight rate
would be.
12.3 DB Equations
[16.5]
[16.6]
Depr. For year t
Depr. Rate
1
1
( )
( ) (1 )
t t
t
t
D d BV
d d B d
=
=
12.3 DB if BV
t-1
Not Known
If BV at the end of the preceding year is
not known, then apply:
1
( ) (1 )
t
t
D d B d

=
[16.7]
12.3 DB: Book Value Determination
BV
t
can be determined in two ways:
1. Using the rate d and the basis, B or,
2. Subtracting the current years
depreciation from the previous years book
value.
BV
t
from d and B:
Apply:
1
(1 )
t
t
t t
BV B d
BV BV D
=
=
[16.8]
[16.9]
12.3 DB: Implied Salvage Value
Note: From equations 16.4 16.9 there
is no mention of the salvage value S!
DB does not directly use the estimated
salvage value.
DB has its own implied salvage value.
The pure DB method will never
depreciate an asset down to a 0 salvage
value unless you solve for a d rate
( Eq. 16.11).
12.3 DB: Implied Salvage Value
The implied salvage value built into the
DB method is:

(1 )
n
n
S BV B d = =
[16.9]
12.3 Implied SV for DB Depreciation
Permissible range for d is:
0 < d < (2/n)
To force a prescribed salvage value S
apply:
Implied d = 1 (S/B)
1/n
[16.11]
12.3 DB rate d
By law, the maximum rate for DB is
specified to =:
Twice the SL rate for a given n.
This is called The Double Declining Balance
Rate.
If d = 1.5 (SL rate), it is termed the 150%
DB rate.
d can never exceed 2(1/n), but can be less!
12.3 Excel DB Functions
Excel supports the DB approach as a
single cell function:
Use:
DDB(B,S,n,t,d) as a cell function.
d argument can be omitted: If so, a d of
2 is assumed by Excel.
Excel also supports a DB function.
Suggest one avoid using this one as special
care must be taken! DB(B,S,n,t)
12.3 Example 16.3
B = $80,000;
n = 10 years;
S = $10,000;
Apply the DB and DDB methods to
compute the depreciation amounts and
associated BVs.
12.3 Example 16.3 DB approach
The DB method first computes the
implied salvage value from:
d = 1 (10,000/80,000)
1/10
= 0.1877
d = 18.77% will target the $10,000 SV at
t = 10.
See Table 16-1 on page 515.
12.3 Spreadsheet Model for Ex. 16.3
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SESSION XII
12.4
MODIFIED ACCELERATED COST
RECOVERY SYSTEM
(MACRS)
ENGINEERING ECONOMY
12.4 MACRS Method
MACRS was derived from the 1981
ACRS system and went into effect in
1986.
Defines statutory recovery
(depreciation) percentages.
Percentages were derived from the DB
method with a switch to SL at the
optimal time and,
Incorporates the half-year convention.
12.4 MACRS Salvage Value
The MACRS approach assumes a
salvage value of 0 even though that
might not be the case!
By current law MACRS assumes all
assets depreciated by this method will
have a 0 salvage value at the end of
the recovery life.
12.4 MACRS Actual Depreciation
Depreciation for year t is:
D
t
= d
t
(B) [16.12]
d
t
= a depreciation rate (per cent)
applicable for the t-th year.
The d
t
s are published percentage
rates and cannot be changed.
12.4 MACRS Book Values
MACRS book values are determined
from:
BV
t
= BV
t-1
D
t
[16.13]
Or,
BV
t
= Basis sum of accumulated
depreciation.
1
j t
t j
j
BV B D
=
=
=
[16.14]
12.4 Observations
Under MACRS:
The entire Basis (B) is fully depreciated
(recovered) over a specified number of
years (recovery periods).
A 0 salvage value is, by law, a functional
part of the MACRS system.
In reality, there may be a positive, 0, or
negative salvage value at some point in
time.
Adjustments will have to be made at that
time. (Disposal Analysis)
12.4 MACRS Recovery Periods
For Personal Property the following
MACRS recovery periods apply:
3- years,
5-years,
7-years,
10-years,
15-years and,
20-years.
Six Property Classes for Personal
Property mid-year convention applies.
12.4 MACRS Personal Property Recovery Rates
Year-t 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 0.3333 0.2000 0.1429 0.1000 0.0500 0.0375
2 0.4445 0.3200 0.2449 0.1800 0.0950 0.0722
3 0.1481 0.1920 0.1749 0.1440 0.0855 0.0668
4 0.0741 0.1152 0.1249 0.1152 0.0770 0.0618
5 0.1152 0.0893 0.0922 0.0693 0.0571
6 0.0576 0.0892 0.0737 0.0623 0.0529
7 0.0893 0.0655 0.0590 0.0489
8 0.0446 0.0655 0.0590 0.0452
9 0.0656 0.0591 0.0446
10 0.0655 0.0590 0.0446
11 0.0328 0.0591 0.0446
12 0.0590 0.0446
13 0.0591 0.0446
14 0.0590 0.0446
15 0.0591 0.0446
16 0.0295 0.0446
17 0.0446
18 0.0446
19 0.0446
20 0.0446
21 0.0223
1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
12.4 Real Property Classes
Real Property buildings, structures,
residential rental and non-residential
office-factory types:
27.5 years for residential rental property;
39 years for all other properties.
Published percentages prorated by months
of the year the property is placed in service.
Assumes a mid-month convention.
12.4 39-Year Depreciation Rates
Straight-Line Method for n = 39.
d = 1/39 = 0.02564 or 2.564% per
year;
Except in year 1 and in year 40 where
technical adjustments are made in the
percentages.
12.4 Recovery Lives
Examine Table 16-2 on page 518.
You will see the 6 Recovery Classes and
their associated percentages.
Note, for each life category there are
n+1 percentage values where n is the
class life.
Example:
In Three-year Recovery period there are 4
recovery percentages!
12.4 Nominal Recovery Periods
3- year property is really recovered
over 4 years;
5-year property is really recovered over
6 years;
And so forth for each of the other
classes.
Why is this the case?
12.4 n+1 Rule
The actual recovery of a given class life
assumes a half-year convention.
That is, it is assumed by law that an
asset is placed in-service at the middle
of the first year.
It does not matter when it is actually
placed in-service;
So, only a year of recovery is
permitted in the first year.
12.4 n+1 Explained
By law, year of recovery is permitted
in the first year and,
The remaining recovery is spread out
over n additional years.
See Appendix 16A.3 for more details.
12.4 Derivation of the 3-Year MACRS Rates
For recovery periods of 3,5,7, and 10
years, the 200% DB with a switch to
straight line is imposed.
For n = 3, the straight-line rate is 1/3.
Twice the straight-line rate is 2(1/3) or
2/3. (0.6667)
Assume a basis of $1.00 for simplicity;
Let the original basis at time t = 0 =
1.000.
12.4 3-Year analysis: First Year
B = 1.000
DDB rate = 0.6667;
But only year in year 1 is permitted
by law so,
d
1
= 0.6667/2 = 0.3333;
D
1
= (0.3333)(1) = 33.33%
BV
1
= 1 0.3333 = 0.6667 remaining
at the end of year 1.
12.4 Year 2
BV at the end of year 1: 0.6667B;
To be recovered over 3 years.
Rate for year 2 is (from DDB)
0.6667(0.6667) = 0.4445 or 44.45%
So, d
2
= 44.45% and,
D
2
= 44.45% of B.
BV
2
= BV
1
D
2
= 0.6667B 0.4445B;
BV
2
= 0.2222B ( 2 years remaining to recover).
12.4 Year 3: Should one switch to SL?
BV
2
= 0.2222B;
SL amount over 2 years would be:
0.2222/2 = 0.1111 for each year;
What is the MACRS deduction for year 3 if DDB is
applied?
d
3
= 0.6667(0.2222B) = 0.1481 or 14.81%
Which is greater for year 3?
11.11% by switching or,
14.81% by staying with DDB?
Ans: Go with the 14.81% greater than
11.11%
12.4 Year 4
Take the 14.81% of the Basis for
year 3;
Book value at the end of year 3 will be
BV
2
D
3
= 0.2222B - .1481B = 0.0741B.
If BV
3
= 0.0741B and there is only one
more year remaining, then to achieve a
0 salvage value at the end of year 4
we take d
4
= 0.0741 we are done!
12.4 Completed MACRS 3-Year Rates
t
d
t
BV
t

1 0.3333 0.6667B
2 0.4445 0.2222B
3 0.1481 0.0741B
4 0.0741 0
1.0000
Blank & Tarquin: 5
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SESSION XII
12.5
DETERMINING THE MACRS
RECOVERY PERIOD
ENGINEERING ECONOMY
12.5 MACRS Recovery Periods
For book depreciation one should use a
life the best reflects the anticipated or
expected useful life.
For tax depreciation one generally wants
as short as possible recovery period to
generate more immediate tax savings.
For book depreciation use whatever life
best defines the usage rate of the asset.
12.5 MACRS Recovery Lives
For Federal tax purposes, the proper
recovery life is found from IRS
publications (Pub 946).
Table 16-4 illustrated general asset
descriptions and their respective MACRS
recovery periods permitted by law.
These breakdowns are termed Property
Classes.
12.5 Property Classes Examples
3-Year Property:
Special manufacturing and handling devices,
tractors and racehorses.
5-Year Property:
Computers and peripherals,
Duplicating equipment.
Automobiles, trucks, buses,
Cargo containers,
Some manufacturing equipment.
12.5 Property Class Examples
7-Year Property Class:
Office furniture,
Some manufacturing equipment,
Railroad cars, engines and tracks,
Agricultural machinery,
Petroleum equipment and natural gas
equipment,
All property not in another class!
The 7-year class is the default class!
12.5 MACRS Recovery Lives
10-Year Class:
Water transportation equipment,
Petroleum refining,
Agricultural processing equipment,
Durable goods manufacturing equipment,
Ship building.
12.5 Property Classes continued
15-Year Class:
Land improvements,
Landscaping,
Pipelines,
Nuclear power production equipment,
Telephone distribution and switching
equipment.
20-Year Class:
Municipal sewers, (developers)
Farm buildings,
Telephone switching equipment,
Power production equipment,
Water utilities equipment.
27.5-Year Property: (Real Property)
Residential rental property (homes and
mobile homes).
39-Year Property (Real Property)
Nonresidential real property attached to the
land, but NOT the land itself.
12.5 Recovery Classifications
Engineers should have access to the
current IRS publications regarding
property classes.
If, in doubt, an inquiry can be made (in
writing) to the regional office of the IRS
for a ruling as to what class questionable
property will be accepted.
12.5 The Alternate Depreciation System
The IRS offers what is termed the
Alternate Depreciation System ADS.
It is a modified form of the MACRS
system.
Applies a straight-line approach with the
half-year convention.
Generally used by small or growing firms
that do not have sufficient taxable
income now and in the immediate future.
12.5 ADS: Overview: 5-Year Example
ADS applies a form of the straight-line
method with the half-year convention.
Assume 5-Year Property Class;
n = 5;
1/n = 0.20 per year except in the first year
and in the last year (n=6)
Year 1: d
1
= (0.20) = 0.10 or 10% of B
Years 2-5 = 0.20 or 20% of B;
Remaining amount 10% flows over to the
last year, t = 6.
12.5 ADS: 5-Year Rates Tabulated
t
d
t
BV
t

1 0.10 0.90B
2 0.20 0.70B
3 0.20 0.50B
4 0.20 0.30B
5 0.20 0.10B
6 0.10 0
1.00
12.5 ADS: Reason For
The ADS is available to smaller firms or
firms that are just starting up.
Some firms may not be generating
sufficient profits to take advantage of
the more accelerated depreciation rates
that the MACRS-GDS provides.
Thus, if GDS is elected, the firm may be
losing deductions in the early years.
ADS provides some relief for firms in
this situation.
12.5 ADS: Election
For both the ADS and the GDS:
For a given tax year the firm elects either
the:
ADS system for all assets placed in
service for the current tax year or,
The GDS (accelerated method) for all
assets placed in service for the current
tax year.
The firm cannot mix ADS with GDS
within the tax year! (It must be one or
the other.)
12.5 ADS GDS:
In engineering economy analysis of
industrial projects:
Most analysis will be accomplished using
the GDS accelerated depreciation rates.
Blank & Tarquin: 5
th
SESSION XII
12.6
DEPLETION METHODS
ENGINEERING ECONOMY
12.6 DEPLETION
Depreciation or cost recovery is applied
to assets that can be replaced.
Depletion applies to resources that are
not easily replaced, like:
Timber,
Mineral deposits,
Oil and gas,
Etc.
12.6 DEPLETION: Two Types
Cost Depletion
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 firms current taxable
income.
12.6 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 p
t
for year t is
calculatednext slide
12.6 DEPLETION: Cost Depletion Factor
Let t denote the year;
p
t
denotes the depletion factor for year
t.
Then, p
t
is defined as:
first cost
resource capacity
t
p =
[16.15]
12.6 DEPLETION: Cost Method Example
Example 16.5, page 523
Company buys timber rights to land for
$700,000 at time t = 0.
Estimated 350 million board feet that
can be harvested.
This is important: A realistic estimate of the
resource must be accomplished up front!
Re-estimates can be made in the future and
adjustments made.
12.6 DEPLETION: Important Issue
Major Point for 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.

12.6 DEPLETION: Example 16.5
Determine the cost depletion amount for
the first two years of harvesting if:
Year 1: Harvest 15 million bdft and,
Year 2: Harvest 22 million bdft.
Compute p
t
as:
p
t
= ($700,000)/350 m-bdft = $2,000/m-bdft.
Depl
t=1
= 15M-bdft($2,000) = $30,000.
Depl
t=2
= 22M-bdft($2,000) = $44,000.
Year 1 depletion allowance = $30,000
Year 2 depletion allowance = $44,000
For year 1 the $30,000 can be treated
as a deduction from gross income so
long as the depletion amount does not
exceed the first cost of the resource.
Likewise, $44,000 can be deducted from
year 2s Gross Income.
12.6 DEPLETION Example
For the first 2 years the recovery is:
Year 1:
$700,000 - $30,000 = $670,000 left to
recover:
Year 2:
$670,000 - $44,000 = $626,000 left to
recover.
This process continues as long as the
original estimate applies.
12.6 DEPLETION Example
Original Estimate 350 m-bdft
After years 1 and 2, 37 m-bdft have
been extracted, leaving an estimated:
350 37 = 313 m-bdft of the resource left.
This process continues until the original
$700,000 investment is written off,
or.
A revised estimate of the resource is
made.
12.6 DEPLETION: Revision of the Resource
Assume at the end of year 2 the
resource capacity is re-estimated.
Assume the re-estimate reveals that
there is 450 m-bdft remaining to start
year 3.
Revision of the factor is now necessary.
Remember, $626,000 remains from the
initial investment of $700,000.
12.6 DEPLETION Revision for Year 3 on
Cost basis for year 3 is $626,000
New p
t
is calculated as:
p
t
= $626,000/413 = $1,516/M-bdft.
For years 3 on the $1,516/m-bdft is applied
to calculate the depletion allowance.
Use this factor until the $700,000
investment is fully written off, or another
re-estimation is conducted.
The process stops when the $700,000 is 0.
12.6 DEPLETION: Percentage Depletion
Percentage depletion uses IRS-
mandated percentages for classes of
resources.
The depletion allowance for this
method cannot exceed 50% of the
firms taxable income before the
depletion allowance is claimed.
Percent Depletion =
Percentage (gross income from activity)
12.6 DEPLETION: Percent Method
Deposit Percentage
Sulfur, uranium, lead,
nickel, zinc,

22%
Gold, silver, copper,
iron ore, and
geothermal deposits

15%
Oil and gas wells
15%
Coal, lignite, sodium
chloride
10%
Gravel, sand, peat,
stone
5%
Most other minerals
14%
12.6 DEPLETION: Percent Method
Warning:
These percents change over time due to
changes in the tax law.
If you are involved in extraction industry
analysis you must keep up with the current
regulations and percents for this method!
12.6 DEPLETION
See Example 16.6 on page 524.
Gold mine purchased for $10 million.
Estimated gross income for years 1-5 of
$5.0 million and $3.0 million after
year 5.
Depletion charges cannot exceed 50%
of taxable income in any given year (by
current tax law).
For gold, the rate is 15%/year.
Years 15:
(0.15)(5.0 million) = $750,000/year
Years 5 on
(0.15)(3.0 million) = $450,000/year
First 5 years:
Write-off = (5)($750,000) = $3.75 million
There is $10 million - $3.75 m = $6.25 m left.
Years 6 on
5 + 6.25 m/$450,000 = 5 + 13.9 = 19 years
The $10 m is fully recovered after 19 years.
12.6 Depletion Law Requirement
The depletion allowance can be
determined using either the cost or the
percentage method.
The current law requires:
Cost depletion can be used IF the percentage
depletion is smaller in any year.
This means that one should apply both
methods in the beginning.

12.6 Depletion Law Requirement
Calculate both amounts:
Cost Depletion ($-Depl)
And percentage Depletion (%-Depl)
Then apply the following rule each year:

%Depl if %Depl $Depl
Annual Depletion =
$Depl if %Depl $Depl
>

`
)
Blank & Tarquin: 5
th
SESSION XII
Chapter Summary
ENGINEERING ECONOMY
Summary
Depreciation may be determined for
internal company records (book
depreciation), or for income tax
purposes (tax depreciation).
In the U.S., the MACRS method is the
only one allowed for tax depreciation.
Depreciation does not result in actual
cash flows directly; rather, tax savings
are the result of depreciation.
Summary
It is a book method by which the
capital investment in tangible property
is recovered.
The annual depreciation amount is tax
deductible, which can result in actual
cash flow changes.
Summary: Straight-Line Depreciation
It writes off capital investment linearly
over n years. The estimated salvage
value is always considered.
This is the classical, nonaccelerated
depreciation model.
Simple to apply and is a popular
method for computing book
depreciation.
Summary: Declining Balance
The model accelerates depreciation
compared to straight line.
The book value is reduced each year by
a fixed percentage.
The most used rate is twice the SL rate,
which is called double declining balance
(DDB).
Summary: Declining Balance
It has an implied salvage that may be
lower than the estimated salvage.
It is not an approved tax depreciation
method in the U.S.
It is frequently used for book depreciation
purposes.
It may not target a specified salvage value.
MACRS applies a modification of this
method to determine MACRS recovery
percents.
Summary: MACRS
It is the only approved tax depreciation
system in the United States. It
automatically switches from DDB or DB
to SL depreciation.
It always depreciates to zero; that is, it
assumes S = 0. Recovery periods are
specified by property classes.
Depreciation rates are tabulated.
Summary: MACRS
The actual recovery period is 1 year
longer due to the imposed half-year
convention.
MACRS alternate straight-line
depreciation is an option, and is
generally used by firms that are
growing and would be wasting MACRS-
accelerated depreciation amounts.
Summary: Depletion
Depletion methods are used to recover
investment in the extraction or
harvesting of natural resources.
Two Methods:
Cost Depletion,
Percentage Depletion.
Specific rules apply to both methods.
Normally, one would calculate depletion
allowances by both methods, then apply the
IRS-mandated permission rules.
Blank & Tarquin: 5
th
SESSION XII
End of Slide Set
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ENGINEERING ECONOMY

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