ESM 450
April 15, 2010
Dr. Robert A . Perkins, PE
253 Duckering
raperkins@alaska.edu
Topics
• Depreciation, Taxes, After Tax Rate of Return
• Inflation
• FE Exam
• http://www.faculty.uaf.edu/ffrap/Presentation
s/PresentationsIndex.htm
After Tax Analysis
• Depreciation
• Allocate Cost over life
– Why?
• Pay tax on net income, that is revenue less
expenses
• Depreciation is an expense
– It is a “real” expense?
Chapter 8 In-class Example A
Net or Tax at
YEAR Revenue Expenses Taxable
52% After Tax
Income
Income
0
1
50
20
30
15.6
14.4
2
50
20
30
15.6
14.4
3
50
20
30
15.6
14.4
4
50
20
30
15.6
14.4
Chapter 8 In-class Example C Net Cash
Net or
Tax at
YEAR Revenue Cash
Income Cost of
Taxable
52% After Tax
Expenses
New PrinterIncome
Income
0
25
1
50
20
30
25
5
2.6
27.4
2
50
20
30
30
15.6
14.4
3
50
20
30
30
15.6
14.4
4
50
20
30
30
15.6
14.4
Total 4 yrs
70.6
Chapter 8 In-class Example C Net Cash
Net or Tax at
YEAR Revenue Cash
Income Cost of Taxable 52% After Tax
Expenses
New PrinterIncome
Income
0
25
1
50
20
30
30 15.6
14.4
2
50
20
30
30 15.6
14.4
3
50
20
30
30 15.6
14.4
4
50
20
30
25
5 2.6
27.4
Total 4 yrs 70.6
so 70.6 is same, what's the difference?
YEAR
0
1
2
3
4
Revenue Cash
Income
Expenses
50
50
50
50
20
20
20
20
30
30
30
30
Cost of
Taxable
New PrinterIncome
25
25
5
30
30
30
assume i=15%
52% After Tax
Income
2.6
15.6
15.6
15.6
Total 4 yrs
PW
27.4
14.4
14.4
14.4
70.6
$52.42
0
1
2
3
4
25
50
50
50
50
20
20
20
20
30
30
30
30
25
30
30
30
5
$52.42
$48.54
$3.87
15.6
14.4
15.6
14.4
15.6
14.4
2.6
27.4
Total 4 yrs
70.6
PW
$48.54
7.39%
So the difference
• Our way, taking all the expense in year 1 gives
us almost $4 more.
• How much did it cost us?
Depreciation Wars
• Any reasonable method is OK as accounting
tool
• Want to accelerate depreciation
• IRS has mandated methods
• Congress has changed
• Today really only two
• SL and MACRS
Straight Line
• SL is always OK with IRS
• Conservative, “saves” depreciation for later
• Estimate Salvage Value and Life of asset
Cost  SV
D each year 
Life ( yrs)
MACRS
• Modified Accelerated Cost Recovery System
– Establish “property class”
• Roughly equivalent to useful life
– Based on IRS publication
– Table indicates % depreciation each year
– Note there is one more year of depreciation than
the life.
Examples
• Three-year property:
– Tool, fabricated metal products, some motor
vehicles
• Five-year property
– Autos and trucks, computers, aircraft
• Seven-year property
– Office furniture
• Etc.
MACRS Depreciation %
Year
1
2
3
4
5
6
7
8
3-year prop.
33.33
44.45
14.81
7.41
5-year prop.
20.00
32.00
19.20
11.52
11.52
5.76
7-year prop.
14.29
24.49
17.49
12.49
8.93
8.92
8.93
4.46
• Each year the depreciation is the initial cost
times the % from the table.
• Note the difference with straight line, where
the estimated salvage value is subtracted from
initial cost. There is no salvage value in
MACRS.
Book Value
• For each year, the book value is the initial cost
minus the depreciation taken to date.
• After the last year, the book value:
– straight line method is the salvage value.
– MACRS method is zero
Book Value
• Note conflict:
– Want to take early depreciation to reduce taxes
– Want high book value to maximize assets
• Also, if you sell, before or after useful life:
– Pay tax on the difference between book value and
sales price
– If you sell for less than book value this is added to
costs for the year.
Buy $9000 production equipment
3 year life $500 SV
0
Dep.
Book V.
1
2833
2
2833
3333
3
2833
500
4
0
500
5
0
500
<=(9000500)/3
9000
6167
Buy $9000 production equipment
$500 SV (3 year MACRS life)
0
MACRS Dep.
%
1
33.33
3000
Book
Value=> 9000
9000*% 6000
2
44.45
4000
9000*%
2000
3
14.81
1332
9000*%
668
4
7.41
667
9000*%
0
5
0
You can now do a rate of return
analysis
• “before tax”
• “after tax”
• For after tax you need to know the tax rate
and the MACRS life
Other methods
• Of historical interest only
– Declining balance
– Sum of years digits
• Depletion
– Extractive industries
• "The legal right of a taxpayer to decrease
the amount of what otherwise would be his
taxes, or altogether avoid them, by means
which the law permits, cannot be
doubted." Supreme Court Justice George
Sutherland in: (Gregory v. Helvering,
(1934) 239 US 465,460.)
•
• "Anyone may so arrange his affairs that his
taxes shall be as low as possible; he is not
bound to choose that pattern which will best pay
the treasury; there is not even a patriotic duty to
increase one's taxes." Supreme Court Justice
Learned Hand in (Helvering v. Gregory, (1934) 69
F 810.)
Income Taxes
• Personal Income Taxes
– Many rules change
– We will not cover these
• Corporate Taxes
– More stable rates
– Often important in engineering decisions.
• Sub-chapter “S”
Basics
•
•
•
•
•
•
•
•
Income
Less, Operating Expenses
Less, Special Expenses
Less, Depreciation
= Taxable Income
Taxable Income x Tax Rate ( %)
= Tax
Net Income (Net Profit) = Taxable Income –
Tax
Inflation
Inflation
• Let’s consider MARR
– What is reasonable?
– What are equivalent investments ?
• Risks
– Inflation is one risk
– Risk we will be paid back with cheaper dollars
Meaning and Effect of Inflation
• Inflation makes future dollars less valuable than
present dollars.
– A sandwich that cost $3.00 last year and $3.30 this year is
an example of individual item inflation of 10%.
– If the average price of bread purchased moves from $1.50
last year to $1.575 this year, the commodity “bread” has
inflated 5%/year.
– If a market basket of goods used by the average individual
costs $15.5994 this year vs. $15.1451 last year, general
consumer inflation has increased by 3%/year.
“Clouded his future is…
The future is always in motion”
Effect of Inflation
• Inflation causes the value of money to be reduced
in the future.
• Inflation tends to cause goods and services to cost
more.
• Inflation is pervasive; In the US we like to see
inflation maintained at around 2% per year.
– Maybe???
–
http://www.frbsf.org/publications/economics/letter/2001/el2001-03.html
Deflation is negative inflation. Goods cost less in the
future. A rare event.
How Does Inflation Happen?
• Money supply increases - money available to
consumers in the general economy increases
faster than the goods available.
• Exchange rates - prices change to reflect the
comparative value of currencies in different
countries.
• Cost-push inflation - producers raise prices to
cover costs.
• Demand-pull inflation - consumers bid up prices
by attempting to buy more than is available.
Interest Rate Definitions
• Inflation rate (f) - rate of change of the the cost of
an item, commodity or market basket of goods.
• Real interest rate (i*) - “real” interest earned on
an investment - the inflation-free interest rate.
• Market interest rate (i) - the interest paid for
borrowing money in the open market, the
combined interest rate. NOTE: the market interest
rate also includes a margin for the lenders risk.
Calculation of Inflation
i = i’ + f + (i’)(f)
Example 13-1 expanded
Market
interest
rate
i
7.50%
7.50%
7.50%
7.50%
7.50%
7.50%
7.50%
7.50%
Inflation
rate
f
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
Real
interest
rate
i'
5.39%
4.37%
3.37%
2.38%
1.42%
0.47%
-0.46%
-1.38%
Inflation
Inflation
Inflation
Inflation
Inflation
Inflation
Deflation
Deflation
• i = i’ + f + (i’)(f)
Limited to the question of
decomposing an interest rate
given i’ or f.
Dollars
• Actual Dollars
– Number of greenbacks you will get.
– Rental/or note says, “$500/month for 60 months.”
• Real Dollars
– “Year zero dollars”
– 1983 dollars.
Actual Dollars and Real Dollars
Definitions
• Actual dollars (A$): cash money - the kind
you carry in your pocket. Sometimes called
inflated dollars.
• Real dollars (R$): constant purchasing
power dollars expressed as a base year.
1972-based dollars. These fictitious dollars
are inflation-free dollars.
• US inflation and spending patterns.
Effect of Inflation on Purchasing Power
Example added.
Your age
Year
20
21
22
23
24
25
26
27
28
29
30
40
50
60
70
80
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2021
2031
2041
2051
2061
Inflation rate for
hamburgers
Market interest rate
(your earnings growth rate)
3%
4%
Hamburgers
Cost of
purchased
Spendable
each
for $312
dollars (real)
hamburger
actual
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
1.67
1.72
1.77
1.82
1.88
1.94
1.99
2.05
2.12
2.18
2.24
3.02
4.05
5.45
7.32
9.84
186.83
181.38
176.10
170.97
165.99
161.16
156.46
151.91
147.48
143.19
139.02
103.44
76.97
57.27
42.62
31.71
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
312.00
324.48
337.46
350.96
365.00
379.60
394.78
410.57
426.99
444.07
461.84
683.63
1,011.94
1,497.92
2,217.29
3,282.12
Inflation is a thief as it robs the
purchasing power of individuals
on fixed incomes.
Hamburgers
purchased w
spendable
dollars
186.83
188.64
190.47
192.32
194.19
196.07
197.98
199.90
201.84
203.80
205.78
226.65
249.64
274.97
302.86
333.58
In 1961 when McDonalds first
opened in Flint Michigan:
•Hamburger $0.14
•Fries (small) $0.11
•Shake (small) $0.18
What will this meal cost in 40
years when you are 60 and
about to retire?
• http://www.clevelandfed.org/research/inflati
on/us-inflation/cpi.cfm
• Cleveland Fed (see tabs)
Calculations
• Excel
FE Review
What is FE
• Fundamentals of Engineering
– AKA “EIT”
• Tests basic knowledge
• Prepared by NCEES
– National Council of Examiners of Engineering and
Surveying
– http://www.ncees.org/
Books and Calculators
•
•
•
•
•
No books
Some calculators banned
NCEES “Supplied-Reference Handbook
Download pdf and print
http://www.ncees.org/exams/study_materials
/#fe
• Will get an identical at exam.
Licensure
• In order to protect the public health and
safety
• Requires
• Education
• Experience
• Examination
• Exam has AM and PM sessions
– four hours each
• 120 multiple choice questions in AM
– That’s two minutes each
• 60 multiple choice in PM
– Four minutes each
• Take home message?
Not to worry
• No one gets 100%
• You only need 70%
Econ Specifications for AM
• VI. Engineering Economics 8%
• A. Discounted cash flow (e.g., equivalence, PW,
equivalent annual cash flow, FW, rate of return)
• B. Cost (e.g., incremental, average, sunk,
estimating)
• C. Analyses (e.g., breakeven, benefit-cost)
• D. Uncertainty (e.g., expected value and risk)
For PM, General
•
•
•
•
•
IV. Engineering Economics 10%
A. Cost estimating
B. Project selection
C. Lease/buy/make
D. Replacement analysis (e.g., optimal
economic life)
• No Econ in PM for
• Civil, Mechanical, or Electrical
• Note most engineering students take either a
3-credit class in economics or nothing.
Let’s do AM
• A. Discounted cash flow (e.g.,
equivalence, PW, equivalent annual cash
flow, FW, rate of return)
• Go to Overheads
• Must use formulas and tables, not Excel
• See Appendix
• You estimate your new generator will require
a major overhaul at five and 12 years after it is
installed. Each overhaul cost $85,000. Assume
it will be junked at the end of year 15, before a
third overhaul is needed. What is the
equivalent annual cost of the two overhauls if
i=8% ?
•
•
•
•
(On board)
All needed factors are in Handbook
An relevant tables.
With that, all should be direct, except finding Rate of
Return
– don’t try to inverse formulae
• Solve for factor, then work backwards in tables
– Linear interpolation is fine, if you need it.
Problems
• Board and Overheads.
B. Cost (e.g., incremental, average,
sunk, estimating)
• Incremental two meanings
– Means the difference between alternatives
– Which is all we have to analyze
– As we have done in 450, or
• The cost of the next unit
– one more unit, relates to next
• Average
– Fixed versus variable
Fixed vs. Variable Costs
• Fixed
– Many overhead costs, boss, rent, etc.
– Must pay no matter how many units you make
• Variable
– per unit extra cost
• For Average
– Divide the fixed by the number of units and add the unit
cost
– Duh
Sunk
Estimating
• No idea
• Common sense
• Nothing in Handbook
C. Analyses (e.g., breakeven,
benefit-cost)
• Benefit Cost, see book
• Breakeven
– Bear Air
– Consulting firm
D. Uncertainty (e.g., expected value
and risk)
• You are familiar with expected value
• Just multiply the probabilities by there value
• Probabilities must add to one.
PM General
• IV. Engineering Economics 10%
• A. Cost estimating
• We’ve done that
B. Project selection
•
•
•
•
Compare alternatives, a la, PW or EACF
Sometimes
Find project with greatest rate of return
one pot of money
– pick project with greatest return
– then second
– until pot is empty.
C. Lease/buy/make
• Just breakeven by another name
• Fixed vs. variable costs
D. Replacement analysis (e.g.,
optimal economic life
• Find life that EACF is minimum
• Did in 450
• But too complex for FE