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– Depreciation

– Taxes (CORPORATE FLAT RATE = 21%)

– Bonds

DEPRECIATION

• FIXED ASSETS LOOSE THEIR VALUE - BEST EXEMPLIFIED BY PERSONAL AUTOMOBILES

• 1999 Jaguar XJ8 original price $65,000. I bought it in 2007 for $12,000, Kelly Blue book today $2500-$3700

• THIS LOSS IS CALLED DEPRECIATION

• ECONOMIC DEPRECIATION GRADUAL LOSS OF UTILITY WITH TIME = PURCHASE PRICE -MARKET VALUE

• ACCOUNTING (OR ASSET) DEPRECIATION -- ALLOCATING THE COST OF THE ASSET OVER ITS DEPRECIABLE LIFE. TRIES TO MATCH ECONOMIC DEPRECIATION

• DEPRECIATION IS A TAX DEDUCTABLE EXPENSE

• FUNCTION – SPREAD THE TAX ADVANTAGE OVER THE PERIOD OF USEFULNESS

• THE ONLY CASH FLOW OF AN ASSET IS IN THE YEAR OF PURCHASE AND YEAR OF DISPOSAL

WHAT IS DEPRECIABLE?

ITEMS THAT ARE:

1. USED IN BUSINESS AND HELD FOR THE PRODUCTION OF

INCOME

2. HAVE A DEFINITE SERVICE LIFE LONGER THAN A YEAR

3. MUST WEAR OUT, DECAY, BE USED UP, BECOME OBSOLETE

4. MUST COST MORE THAN $2500

WHO CAN DEPRECIATE ASSETS?

• ANYONE WHO USES THE ASSET FOR BUSINESS

PURPOSES AND MEETS THE RULES ON THE PREVIOUS

SLIDE

COST BASIS

• COST BASIS

IS:

• THE TOTAL COST OF THE ASSET OVER ITS LIFE

– INITIAL INVESTMENT

– FREIGHT

– SITE PREPARATION

– INSTALLATION

– TRADE-IN ALLOWANCE OF THE PREVIOUS EQUIPMENT

• IT DOES NOT INCLUDE OPERATING EXPENSES

OTHER DEFINITIONS

• THE

BOOK VALUE

EQUALS THE COST BASIS LESS THE

ACCUMULATED TOTAL DEPRECIATION

• SALVAGE VALUE

- ESTIMATED VALUE AT THE END OF AN

ASSET’S LIFE

• DEPRECIABLE LIFE

- NUMBER OF YEARS THAT THE ASSET

CAN BE USED

• ASSET DEPRECIATION RANGE (ADR)

- PRESCRIBED

GUIDELINES BY THE IRS FOR DEPRECIABLE LIFE

• IRS - INTERNAL REVENUE SERVICE

-- ENFORCES TAX

RULES CREATED BY CONGRESS AND COLLECTS THE

TAXES

DEPRECIATION METHODS

•

DEPRECIATION IS CALCULATED TWO WAYS, EACH WITH ITS OWN

PURPOSES

•

BOOK DEPRECIATION

– FINANCIAL REPORTS

– INCOME STATEMENTS

– REFLECTS ACTUAL LOSS IN VALUE

– STATE TAXES AND FEDERAL TAXES BEFORE 1981

•

TAX DEPRECIATION

– TO CALCULATE TAXES FOR THE IRS

– TAKES ADVANTAGE OF TAX RULES

– USUALLY LEADS TO BETTER CASH POSITION IN EARLIER

BOOK DEPRECIATION METHODS

• STRAIGHT LINE (SL)

• ACCELERATED

– DECLINING BALANCE (DB)

– DOUBLE DECLINING BALANCE (DDB)

– DECLINING BALANCE WITH CONVERSION TO SL

• UNIT OF PRODUCTION

)

...

(

)

(

2 1 n n N

D

D

D

I

B

N

S

I

D













DECLINING BALANCE METHOD

• USES A FIXED FRACTION (alpha) OF THE BEGINNING BOOK

BALANCE EACH YEAR:

• MULTIPLIERS:

– 1.5 OR 150% DB

– 2.0 OR 200% OR DOUBLE DECLINING METHOD (DDB)



1

/

N



(

multiplier

)





n n N N

I

B

D

D

D

TotalDB

I

D

)

1

(

....

)

1

(

2 1 1























DECLINING BALANCE WITH CONVERSION TO STRAIGHT LINE

• WHAT DO WE DO IF THE DB METHOD DOES NOT RESULT IN

THE ESTIMATED SALVAGE VALUE?

1. IF B

_N

> S

– WE HAVE NOT DEPRECIATED THE ASSET FULLY

– SWITCH TO STRAIGHT LINE THE FIRST YEAR THAT THE

STRAIGHT LINE DEPRECIATION IS GREATER THAN THE

DB METHOD

2. B

_N

< S

UNITS - OF - PRODUCTION METHOD

• ALLOCATES THE DEPRECIATION IN PROPORTION TO THE

HISTORY OF DEPRECIATION METHODS

• UNTIL 1954 - STRAIGHT LINE ONLY

• 1954 - 1981 --ADDED ACCELERATED METHODS:

– DECLINING BALANCE (DB)

– DOUBLE DECLINING METHOD (DDB)

– SUM OF THE YEARS’ DIGITS (SOYD) (WE DO NOT

COVER)

• 1981

– REPLACED BY ACCELERATED COST RECOVERY

SYSTEM (ACRS)

2017-2018 MODIFICATIONS

• $1000 TO $2500

• Bonus in year of acquisition

– $1M per item, $2.M max (sometimes quoted half that – we

will us the larger amount

• Survey only, not tax advice – always use a tax specialist if

you are in business

• Also extra 50% in first year for eligible equipment

• We will assume all equipment is eligible

MODIFIED ACCELERATED RECOVERY SYSTEM (MACRS) FOR

TAX PURPOSES

• SALVAGE VALUE ALWAYS ZERO

• RECOVERY PERIOD

-- ARBITRARY LIFE FOR THE

INVESTMENT, NOT NECESSARILY EQUAL TO ACTUAL LIFE

– EIGHT CATEGORIES: 3, 5, 7, 10, 15, 20, 27.5, 39 YEARS

• 3, 5, 7 AND 10 YEARS - USE 200%DDB, SWITCH TO SL

• 15 AND 20 YEARS -- USE 150%DDB AND SWITCH TO SL

• 27.5 YEARS RESIDENTIAL RENTAL -- SL

• 39 YEARS COMMERCIAL BUILDINGS -- SL

HALF YEAR CONVENTION

• FOR EQUIPMENT PLACED IN SERVICE USING MACRS:

• ALL ASSETS ARE ASSUMED TO BE PLACED IN SERVICE IN

THE MIDDLE OF THE YEAR (some change here that we will

ignore)

• ALL SALVAGE VALUE IS ZERO

• ONLY A HALF YEARS’ DEPRECIATION IS ALLOWED THE

FIRST YEAR

• THE REMAINING HALF YEAR IS ALLOWED FOLLOWING THE

END OF THE RECOVERY PERIOD

EXAMPLE 9.8

DEPLETION

•

APPLIES TO NATURAL RESOURCES

•

OBJECTIVE IS THE SAME AS DEPRECIATION

•

COST DEPLETION WORKS

JUST LIKE UNITS OF PRODUCTION

-EQUATION 9.9:

COST DEPLETION

=(ADJUSTED BASIS OF MINERAL

PROPERTY)x(NUMBER OF UNITS SOLD) / (TOTAL NUMBER OF

RECOVERABLE UNITS)

•

PERCENTAGE DEPLETION

- PORTION OF GROSS INCOME, LIMITED

BY 50% OF THE TAXABLE INCOME WITHOUT THE DEPLETION

•

ALLOWABLE PERCENTAGES ARE GIVEN IN TABLE 9.11. THESE

RANGE FROM 5% TO 22%

REPAIRS OR IMPROVEMENTS

• For tax depreciation purposes, repairs or improvements made to

any property are treated as separate property items.

• The recovery period for a repair or improvement to the initial

property normally begins on the date the repaired or improved

property is placed in service.

• The recovery class of the repair or improvement is the recovery

class that would apply to the property if it were placed in service

at the same time as the repair or improvement.

EXAMPLE 9.12

• In January 2004, Kendall Manufacturing Company purchased a

new numerical control machine at a cost of $60,000. The machine

had an expected life of 10 years at the time of purchase and a

zero expected salvage value at the end of the 10 years.

• For book depreciation purposes, no major overhauls had been

planned over the 10-year period, and the machine was being

depreciated toward a zero salvage value, or $6,000 per year, with

the straight-line method.

• For tax purposes, the machine was classified as a 7-year MACRS

property.

EXAMPLE 9.12 CONTINUED

• In December 2006, however, the machine was thoroughly

overhauled and rebuilt at a cost of $15,000. It was estimated that

the overhaul would extend the machine’s useful life by 5 years.

DEFINITIONS

• INFLATION

- A LOSS IN THE PURCHASING POWER OF

MONEY OVER TIME

• DEFLATION

- PRICES DECREASE OVER TIME

• CONSUMER PRICE INDEX (CPI)

- COST OF A COMPOSITE

OF GOODS COMPARED TO AN EARLIER TIME

• BASE PERIOD

- TIME TO WHICH WE ARE COMPARING

PRICES

• PRODUCER PRICE INDEX

- PRICE INDEX FOR VARIOUS

INDUSTRIAL PRODUCTS

• COST OF LIVING INDEX

- INCLUDES CHANGES IN BUYING

HABITS

CALCULATING AVERAGE INFLATION RATES

• FROM SUCCESIVE INDECES:

• FROM TWO POINTS IN TIME (single payment compound

amount factor)

index

s

year'

Previous

index

s

year'

Previous

-index

s

ar'

Current ye

rate

inflation

Average



1

/ 1

















N

P

F

f

EXAMPLE

THE PASSENGER CAR INDEX WAS 113 IN 1988. IT HAD RISEN

TO 133.9 IN 1994. THE AVERAGE INFLATION RATE WAS (A

SPECIFIC INFLATION RATE):

f

_j

= (133.9/113)

1/6

_{-1 = 2.9 %}

WE CAN COMPARE THIS WITH THE CHANGE IN THE CPI OVER

THE SAME PERIOD (THE GENERAL INFLATION RATE):

= f (CPI) = (148.2/118.3)

1/6

_{-1 = 3.8%}

WHAT DOES THIS SAY ABOUT THE RELATIVE COST OF CARS

DURING THAT PERIOD?

CURRENT CPI = 237.805

ACTUAL AND CONSTANT DOLLARS

• CONSTANT DOLLARS

= CONSTANT PURCHASING POWER

INDEPENDENT OF THE PASSAGE OF TIME (A’

_n

)

• ACTUAL OR CURRENT DOLLARS (REAL)

- ESTIMATES OF

FUTURE CASH FLOWS TAKING INTO ACCOUNT

INFLATIONARY EFFECTS (A

_n

)

• EXAMPLES 11.3 AND 11.4





n

n

n

A

f

A



'

1



INTEREST RATE DEFINITIONS

• MARKET INTEREST RATE(i)

(INFLATION ADJUSTED MARR)

-TAKES INTO ACCOUNT EARNING POWER AND INFLATION

EFFECT (USED MOST FREQUENTLY)

• INFLATION FREE INTEREST RATE(i’)

(REAL INTEREST

RATE)- TRUE EARNING POWER OF MONEY

• EVERYTHING WE HAVE DONE SO FAR THIS SEMESTER

USED MARKET INTEREST RATES

f

i

f

i

RECENT INFLATION RATES

1984 311.1 4.3 1985 322.2 3.6 1986 328.4 1.8 1987 340.4 3.6 1988 354.3 4.1 1989 371.3 4.8 1990 391.4 5.4 1991 408 4.2 1992 420.3 3 1993 432.7 3 1994 444 2.2 1995 456.5 2.8 1996 469.9 2.9 1997 480.8 2.3 1998 488.3 1.6 1999 499.1 2.2 2000 515.8 3.4 2001 530.1 2.8

YEARS OF HIGH INFLATION

1864

47

27

1863

37

23.3

1917

38.4

17.4

1918

45.1

17.4

1920

60

15.8

1919

51.8

14.9

1947

66.9

14.4

1813

58

13.7

1980

246.8

13.5

1979

217.4

11.3

1862

30

11.1

1974

147.7

11

SOME HISTORICAL (AND HISTORIC) EXAMPLES

• GERMANY 1923 (2/23 T0 12/23)

• HUNGARY 1945

– NYT story from 1945:

– INFLATION IN HUNGARY; National Bank Pays at Rate of

8,250 Pengos to Dollar

•

HUNGARY TO SLASH LIVING STANDARDS; Drastic Cuts

Ordered ...

• Inflation-crazed Hungary, rocking under the impact of the

maddest of all currency debacles, in which one United States

cent is worth trillions of pengoes, is going ...

SOME HISTORICAL (AND HISTORIC) EXAMPLES

•

Inflation Becomes Nightmare in Hungary With Value of Pengo

...

• BUDAPEST, Hungary, April 4 (Delayed, London Times

dispatch) --In Budapest inflation has now become a

nightmare, with nothing ... like it except the German ...

• April 6, 1946 By Wireless to THE NEW YORK TIMES.

-Business & Finance - Article - Article - Article - Article - Print

Headline: "Inflation Becomes Nightmare in Hungary With

Value of Pengo Dropping Steadily