Taxes and Depreciation
MACRS
Review
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What is Depreciation?
– Decline in value due to wear and tear (deterioration),
obsolescence and lower resale value.
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Why do we compute depreciation?
To reduce net profit before taxes =>Decrease
taxes =>Increase the cash flow after taxes
Review (cont’d)
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How do you compute Depreciation?
– It is computed separately for each asset.
– It depends on
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the age of the asset,
the Initial Cost of the asset (P),
the Tax Salvage of the Asset (S) (sometimes), and
the Tax Life of the asset (N)
Depreciation Methods
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Several depreciation methods exist.
So-called historical or classical methods
– Straight Line
– Sum of the Years Digits
– Declining Balance
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Current method mandated by the government
– Modified Accelerated Capital Recovery System
(MACRS)
Method 4: Modified Accelerated
Capital Recovery System (MACRS)
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MACRS was created in 1986 and prescribed by the IRS
MACRS is now the principal method for computing
depreciation.
MACRS assigns a class (tax life) to various kinds of
property. (Useful life estimates are no longer relevant.)
Most tangible personal property fall in one of the six
categories:
– 3-, 5-, 7-, 10-, 15-, 20-year classes
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Rental property is assigned a 27.5-year tax life
Nonresidential real property is assigned a 31.5-year tax
life)
MACRS (cont’d)
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MACRS gives a percentage depreciation for each
year.
The depreciation is the percentage times the
initial cost.
MACRS gives organizations the choice of two
depreciation systems: General (GDS) or
Alternative (ADS).
GDS is more accelerated and thus most often
preferred.
General Depreciation System (GDS)
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The GDS percentages are computed with a
declining balance method using a switch point.
– Double rate for 3-, 5-, 7- and 10-year classes,
– 1.5 rate for 15- and 20-year classes,
– Straight line method for
» Rental property (27.5 year life)
» Nonresidential real property (31.5 year life)
Half-Year Convention
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The half-year convention assumes that an asset
purchased in a year is purchased in the middle of the
year. Therefore, only half a year of depreciation is
allowed.
Year
1
2
3
4
5
6
3-year class
33.33%
44.45%
14.81%
7.41%
5-year class
20%
32%
19.2%
11.52%
11.52%
5.76%
Recall Example 1: Should we invest?
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New Machine:
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Investment = $11,000
Tax Life and Actual Life = 5 years
Tax Salvage and Actual Salvage = $1,000
Income = $4,000 per year
Operating Expenses = $1,000 per year
40% Tax Rate
After Tax MARR = 9%
Example 1 with MACRS 3-year
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Periods
Before Tax
Cash Flow
Depreciat ion
Taxable
Income
Tax
Aft er Tax
Cash Flow
0
-1 1 00 0
1
3 0 00
3 6 66. 6 7
-6 6 6.3 0
-2 6 6.5 2
3 2 66. 5 2
2
3 0 00
4 8 88. 8 9
-1 8 89. 5 0
-7 5 5.8 0
3 7 55. 8 0
3
3 0 00
1 6 29. 1 0
1 3 70. 9 0
5 4 8.3 6
2 4 51. 6 4
4
3 0 00
8 1 5.1 0
2 1 84. 9 0
8 7 3.9 6
2 1 26. 0 4
5
3 0 00
0
3 0 00
1 2 00
1 8 00
5
Salvage
1 0 00
1 0 00
400
600
-1 1 00 0
At the end of period 5, Book Value= 0
Economic Analysis for MACRS 3-year
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Before-tax NPW
= -11000 + 3000 (P/A, 0.09, 5) + 1000 (P/F, 0.09, 5)
= 1319
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After-tax NPW
= -11000 + 3266.52 (P/F, 0.09, 1) + 3755.8 (P/F, 0.09, 2)
+ … + (1800+600) (P/F, 0.09, 5)
= 117
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Before-tax ROR = 13.34%
After-tax ROR = 9.45%
Example 1 with MACRS 5-year
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Periods
Before Tax
Cash Flow
Depreciation
Taxable Income
Tax
After Tax
Cash Flow
0
-11000
1
3000
2200.00
800.00
320.00
2680.00
2
3000
3520.00
-520.00
-208.00
3208.00
3
3000
2112.00
888.00
355.20
2644.80
4
3000
1267.20
1732.80
693.12
2306.88
5
3000
633.60
2366.40
946.56
2053.44
5
Salvage
1000
-267.20
-106.88
1106.88
-11000
At the end of year 5, Book Value = 11,000 - 2200
- 3520 - 2112 - 1267.2 - 633.6 = 1267.2
Economic Analysis for MACRS 5-year
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After tax NPW = -110
After tax ROR = 8.61%
Summary
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Every problem has three kinds of cash flows
– Investment: cash flow at time 0
– Annual Revenues /Operating Costs: At times 1
through end of life
– Salvage Value: cash flow at end of life
Summary (cont’d)
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Investment
– For new assets, there is no tax effect at time 0.
Year
0
1
2
3
4
4 Sal.
BT Cash Depr
Taxable –Tax
AT Cash
Flow
Income
Flow
-10000
-10000
5000
-2000
3800
3000
+800
2500
500
2800
3000
-200
1250
1750
2300
3000
-700
625
2375
2050
3000
-950
625
1375
1450
2000
-550
Summary (cont’d)
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Annual Revenues / Operating Cost
– ATCF = BTCF - Tax
– Tax = (BTCF - Depreciation)(tax rate)
Year
0
1
2
3
4
4 Sal.
BT Cash Depr
Taxable –Tax
AT Cash
Flow
Income
Flow
-10000
-10000
5000
-2000
3800
3000
+800
2500
500
2800
3000
-200
1250
1750
2300
3000
-700
625
2375
2050
3000
-950
625
1375
1450
2000
-550
Summary (cont’d)
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Salvage Value
– If Book Value (BV) is different than salvage value
(SV), there is a tax effect.
– Salvage ATCF = Salvage BTCF - Tax
– Tax = (SV - BV)(tax rate)
Year
0
1
2
3
4
4 Sal.
BT Cash Depr
Taxable –Tax
AT Cash
Flow
Income
Flow
-10000
-10000
5000
-2000
3800
3000
+800
2500
500
2800
3000
-200
1250
1750
2300
3000
-700
625
2375
2050
3000
-950
625
1375
1450
2000
-550
What tax rate do we use?
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Assume we have a new project with additional
income over the current project.
What tax rate do we use to find the tax on the
additional income?
– Use the tax rate that would be applicable to the next
dollar of income.
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This is the incremental tax rate appropriate to
your highest level of taxable income
When the asset is actually sold for the
price SV, there may be a tax effect.
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If SV > BV then the amount SV - BV is a capital
gain,
– you must pay tax on the capital gain
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If SV < BV then the amount BV - SV is a capital
loss,
– you may deduct the loss from other capital gains and
have tax savings
Conclusions
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All previous analysis methods described work
with tax considerations
Use after tax cash flows and after tax MARR for
analysis
Depreciation of investments is required in
analysis
The method of depreciation may affect the
decision