Taxes & Depreciation

MIT Civil Engineering 1.011 -- Project Evaluation Spring Term 2003

1.011 Project Evaluation Why Worry About Taxes & TAXES & DEPRECIATION Depreciation? C.D. Martland Income taxes are large cash flows that cannot be ignored 1. Depreciation Tax credits and depreciation rules are sometimes used to encourage investments 2. Taxes and we need to understand how that works 3. After-tax cash flows Depreciation is a non-cash expense that results in reduced tax payments After tax results are most meaningful to companies

A VERY General Perspective Depreciation Is an Accounting Mechanism to Transform Investment into Annual Expenses Gross Income (i.e. Revenue) - Expenses Investment is a CASH FLOW but not an EXPENSE - Depreciation "Expenses" are, in accounting terms, amounts that can be deducted from current income to calculate profit = Taxable Income (Net Income Before Taxes) Investments simply transform financial assets into - Income Tax another type of capital asset = Net Income After Taxes (i.e. Profit) After making an investment, you presumably have the same capital value you started with Depreciation is an EXPENSE but not a CASH FLOW ROI = Net Income After Tax/(Invest-Deprec) Depreciation is an ACCOUNTING means of reflecting the consumption of a capital asset as it is used Accounting rules and tax law determine exactly how depreciation and taxes affect cash flows.

Possible Ways to View Depreciation Depreciation Rules

An Engineering Estimate of the decline in The rules will affect profits, net investment (i.e. capability or loss of value in an asset over time investment - depreciation), and ROI Use engineering science to determine rate of Changes in the rules can therefore change the value of depreciation (a truck's life is 10 years or 300,000 miles) the company or of a project! An Accounting Convention that translates What can be depreciated investment expense into reasonable approximations Tangible or intangible assest that are of actual deterioration or life Are used to produce income Use simplified estimates of lives that reflect actual Have a finite, determinable life > 1 year experience (trucks last 10 years, buildings last 30) Deteriorates from use, natural causes or A Policy Tool to promote investment obsolescence Allow shorter lives for depreciating housing for the Are neither inventory nor stock-in-trade elderly to promote private investment Buildings, machinery, vehicles, computers, ...

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Cash Flow vs. Accounting Expense: Methods of Depreciation: Accounting Affects the Cash Flows, NPV, etc. Policy Concerns 20 2 Depreciation 0 0 Simplicity -20 -2 -40 -4 Engineering formulations can be advanced, -60 -6 -80 -8 but they are complicated for everyone involved -100 -10 -120 -12 IRS and companies prefer simplicity to realism Depreciation Expense Before Tax Cash Flow Year Year Promote investment by increasing the NPV 20 20 0 0 of the tax break -20 -20 -40 Shorter asset life -40 -60 -60 Greater depreciation in early years -80 -80 Investment Depreciation -100 -100 Cash Flow -120

Tax Savings After Tax Cash Flow -120 012345678910

Investment or Expense 12345678910 Year

Selected Methods of Depreciation Straight Line Depreciation Straight-line dk = (B - S)/N 5 Equal depreciation per year over life of asset Depreciation Book Value dk = Deprec. year k Declining balance or 4 B = Cost Basis Sum-of-the-years-digits S = salvage value 3 More rapid depreciation in early years N = life

Thousands 2 Modified Accelerated Cost Recovery Book value year k = Salvage System (MACRS) B - k*dk Book Value & Depreciation 1 A limited number of options for useful life 0 Simplify book-keeping 012345678910 Year

Declining Balance Depreciation with Declining Balance Depreciation Switchover to Straight-Line Method d1 = B*R Start with double 5 5 dk = B*(1-R)k-1*R declining balance Depreciation Book Value Depreciation Book Value B = Cost Basis Calculate the annual 4 4 BVk = B*(1-R)k depreciation for the

BVN = B*(1-R)N remaining balance using 3 3 Salvage value is not straight-line method (for the current book value included directly Thousands 2 Thousands Depreciation 2 and the remaining life) R = 1/N is straight line Switch to straight line Depreciation & Book Value 1 R= 2/N is double 1 when that method gives declining balance more depreciation 0 0 012345678910 012345678910 Year Year

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Conventions to Simplify and Taxes Unify Depreciation: MACRS Before Tax Cash Flows Modified Accelerated Cost Recovery System + tax credits - state income tax - fed. income tax introduced by Tax Reform Act of 1986 = After Tax Cash Flows Salvage Value assumed to be 0 More depreciation, less record-keeping Useful life specified by tax code - one of six Tax Credits: directly offset tax payments categories Income Tax: proportional to income Shorter lives, fewer categories, & specified annual Federal rate (FR): typically 34% for large US percentages OR corporations ADS (alternative depreciation system), which is State rate (SR): typically 6-12% (and deductible straight-line and used for some assets from federal tax First and last year assumed to be exactly 6 months Don't bother with actual dates

After Tax MARR Depreciation & Taxes: Summary

Effective income tax rate = SR + FR(1-SR) Depreciation and taxes are important because they affect cash flows Depreciation is based upon accounting rules and the Example: Eff Inc tax rate = .1+.34*.9 = .406 tax code - NOT upon actual physical deterioration Accelerated depreciation increase expenses and After tax MARR = MARR * (1 - eff inc tax rate) reduces profit in the early years of a project, but actually increases tax flow by reducing taxes Not exact because timing and amount Tax credits are equivalent to a reduction in the ofincomevary with depreciation and purchase investment and disposal of assets. The after tax MARR is approximately equal to the pretax rate multiplied by (1 - eff inc tax rate)

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