Lecture 8 (Part 2) Depreciation
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1 Seg2510 Management Principles for Engineering Managers Lecture 8 (Part 2) Depreciation Department of Systems Engineering and Engineering Management The Chinese University of Hong Kong 1
2 Part I Review of the Last Lecture 2
3 Book Depreciation Methods Straight-line (SL) Method Declining-balance (DB) Method Book Value ($) SL Method DB Method 0 Year N Year 3
4 Example DB Switchover SL A new electric saw for cutting small pieces of lumber in a furniture manufacturing plant has a cost of $4,000 and a 10-year depreciable life. The salvage value is $0. Determine the annual depreciation amount using 200%DB method switchover SL method 4
5 Solution Example DB Switchover SL Year BV 200%DB SL Depreciation amount 1 $4, $ $ $ , , , , ,
6 Part II Understanding Money Management 6
7 Tax Depreciation Methods Modified Accelerated Cost Recovery System (MACRS) is the method used to determine the allowed depreciation amount in calculating income taxes. 7
8 MACRS Recovery Periods Recovery period Lifespan of an asset, according to its category. May be different with expected useful life. Under MACRS, depreciation is calculated according to recovery period. Under the MACRS, the salvage value of property is always treated as zero. The MACRS guidelines are summarized as follows: Recovery periods are 3, 5, 7 or 10 years: Using 200% DB, and then switching to SL depreciation. Recovery periods are 15 or 20 years: Using 150% DB, and then switching to SL depreciation. Other properties: Using SL depreciation. 8
9 MACRS Recovery Periods E.g. Computers, automobiles, and light trucks 5 years of recovery period Most types of manufacturing equipment are depreciated over 7 years, but some long-lived assets are written off over 10 years; by using the 200%-DB method and then switching to SL depreciation/ Sewage-treatment plants and telephone-distribution plants are written off over 15 years by using 150% DB and then switching to SL depreciation. residential rental property are written off by the SL method over 27.5 years nonresidential real estate (commercial buildings) is written off by the SL method over 39 years. 9
10 MACRS Depreciation: Personal Property The yearly recovery, or depreciation expense, is determined by multiplying the asset's depreciation base by the applicable recovery-allowance percentage: Half-Year Convention: assumed that all assets are placed in service at midyear and that they will have zero salvage value. Only a half-year of depreciation is allowed for the first year that property is placed in service. E.g. if the original depreciation deduction is $1000 for the first year, then we can only claim for $500 in the 1st year. The remaining half-year's depreciation is incurred in the year following the end of the recovery period. A half-year of depreciation is also allowed for the year in which the property is disposed of, or is otherwise retired from service, anytime before the end of the recovery period. E.g. if the depreciable life is 5 years, then in year 6, we can still claim for depreciation, but the value is halved. Switching from the DB Method to the SL Method: The MACRS asset is depreciated initially by the DB method and then by the 10 SL method.
11 Determining the MACRS percentage E.g. for a 3-year property, Beginning with the first tax year and ending with the fourth year SL rate = 1/3 200% DB rate, = 2(1/3)= S=0 Year 1: ½ year DDB depreciation = 0.5(0.6667) = 33.3% Year 2: DDB depreciation = ( ) = 44.45% SL depreciation = (1/2.5)( ) = 26.67% Year 3: DDB depreciation = ( ) = 14.81% SL depreciation = (1/1.5)( ) = 14.81% Year 4 ½ SL depreciation = 0.5(14.81%) = 7.41% 11
12 Example 1 A firm purchased and placed in service a new piece of semi-conductor. The cost is $5,000 and its useful life is 10 years. It is in the 5 years recovery period in GDS. Determine the depreciation charged Solution: Note: Half year convention Year BV 200%DB SL Depreciation amount 1 $5, $ $ $ , , ,
13 Example 1 (cont d) Solution: According to the rate table, we know that Year BV Rate Depreciation amount 1 $5, $ (5000 x ) 2 4, (5000 x ) 3 2, (5000 x ) 4 1, (5000 x ) (5000 x ) (5000 x ) 13
14 Example 2. A taxpayer wants to place in service a $10,000 asset that is assigned to the five-year MACRS class. Compute the MACRS percentages and the depreciation amounts for the asset. 14
15 Solution 15
16 MACRS Depreciation: Real Property Real properties are classified into two categories: (1) residential rental property and (2) commercial building or properties. The straight-line method and the midmonth convention are used. 16
17 Example 2 On May 1, Jack Costanza paid $100,000 for a residential rental property. This purchase price represents $80,000 for the cost of the building and $20,000 for the cost of the land. Three years and five months later, on October 1, he sold the property for $130,000. Compute the MACRS depreciation for each of the four calendar years during which he owned the property. 17
18 Solution The midmonth convention assumes that the property is placed in service on May 15. which gives 7.5 months of depreciation in the first year. Only the building (not the land) may be depreciated, we compute the depreciation over a year recovery period, using the SL method: Year Calculation Recovery Percentages $80,000 0 = $80,000 0 = 27.5 $1,818 $2, % 3.636% 3 $80, = $2, % $80, = $2, % 18
19 References Chan S. Park, Fundamentals of Engineering Economics. Prentice Hall Lecture 7:Depreciation, by Gabriel Fung
Lecture 8 (Part 1) Depreciation
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