7.

DEPRECIATION
 INTRODUCTION

• Depreciation is the decrease in the value of physical

properties with the passage of time and use.
• A non cash expense that reduce the value of an asset as
a result of wear and tear or age and obsolescence.
• Most assets loose their value over time(in other words,
they depreciate), & must be replaced once the end of their
useful life is reached.
 REQUIREMENTS FOR THE DEPRECIATION
• Properties must be used for revenue generation (i.e. to
produce income).
• Properties must have more than one year useful life.
• Properties must be an asset that decays, gets used up,
wears out, become obsolete or loses value to the owner
from natural causes.
• Depreciable property is a property for which depreciation
is allowed under government income tax laws and
regulations.
• Tangible property (machinery, vehicles, equipment's)
intangible property (copyright, patent goodwill)
• Land is not depreciable properties because it has no
useful life.
• Depreciation stops when it is retired from services.
 REASONS FOR DEPRECIATION
• Use related physical loss
• Time related physical loss
• Function related loss
• Sudden failure
• Depletion
 TERMINOLOGIES
• Cost basis/unadjusted cost - initial total cost of the
assets
• Book value - remaining undepreciated capital investment
on the books after total amount of depreciation changes
to date have been subtracted from the basis at the end of
each year.
• Recovery period - depreciable life “n” of the assets in
years
• Salvage value (SV): estimated value of the properties at
the end of its useful life for a owner.
• Useful life: expected time that will be used to produce
income.
• Market value
• Scrap value : dismantled value of the property
 METHODS OF DEPRECIATION

• Straight line method

• Declining/diminishing balance method(DB)
• Sum of years digit (SOYD) method
• Sinking fund method
• Modified accelerated cost recovery system(MACRS)
 1. STRAIGHT LINE METHOD

• Simplest and most often used method for property

valuation.
• Constant amount depreciated over the useful life.
Dn= (I-S)/N
where, Dn= depreciation change each year
I = cost basis
S= salvage value
N= useful life
• Q. Suppose a motorcycle cost Rs. 3,00,000 to have
estimated life of 8 years and the salvage value is
estimated at Rs. 1,40,000 at the end of the life. Determine
the annual depreciation and annual rate of depreciation.
n Bn-1 Dn Bn
1 3,00,000
2

3
4
5
6

7
8
• Q. Suppose a motorcycle cost Rs. 3,00,000 to have
estimated life of 8 years and the salvage value is
estimated at Rs. 1,40,000 at the end of the life. Determine
the annual depreciation and annual rate of depreciation.
Soln:
Annual depreciation(Dn)= (I-S)/N
= (3,00,000-1,40,000)/8
=20,000
Annual rate of depreciation= 20,000/1,60,000
= 0.125
= 12.5%
• Also find the book value at the end of each year;

n Bn-1 Dn Bn
1 3,00,000 20,000 2,80,000
2 2,80,000 20,000 2,60,000

3 2,60,000 20,000 2,40,000

4 2,40,000 20,000 2,20,000
5 2,20,000 20,000 2,00,000
6 2,00,000 20,000 1,80,000

7 1,80,000 20,000 1,60,000

8 1,60,000 20,000 1,40,000
2.DECLINING/DIMINISHING BALANCE
METHOD(DB)
• Fixed/uniform percentage method
• To determine depreciation at each year, book value at the
start of the year should be multiplied by fix rate(α).
• Most commonly used multiplier are double the straight
line rate, for which it is called as double declining balance
method.
• To determine depreciation change each year;
𝐷1= αI
𝐷2 = α(I- 𝐷1)= α(I-αI)= αI(1-α)
𝐷3= α(I- 𝐷1- 𝐷2)= α{I-αI-αI (1-α)}
= αI (1-α-α+α2)
=αI(1-2α+ α2)
=αI (1−α) 2
………..
…….....
𝐷𝑛= αI (1−α)𝑛−1.......1
• Total declining balance (TDB) at the end of each year n can be
calculated as;
TBD= 𝐷1+ 𝐷2+ 𝐷3+…….+𝐷𝑛
=αI+αI(I-α)+ αI (1−α) 2 +.......+ αI (1−α)𝑛−1
=αI{1+(1-α)+ (1−α) 2 +.........+ (1−α)𝑛−1.........................2
Multiply TDB by (1-α) we obtain,
(1-α)TBD= αI {(1-α)+ (1−α) 2 + (1−α) 3 +.......+ (1−α)𝑛}.........3
Subtracting eqn 2 from eqn 3
TBD= I{1- (1−α)𝑛}
So, Bn= I-TBDn
= I-I{1- (1−α)𝑛}
=I{1-1+(1−α)𝑛}
Bn= I (1−α)𝑛
• Q. Consider following information:
Cost basis of the asset (I)= Rs. 10,000
Useful life(N) =5 years
Estimated salvage value(SV)= Rs. 773
Calculate annual depreciation and the resulting book values using DB method.
n Bn-1 (Rs.) Dn (Rs.) Bn(Rs.)

5
• Q. Consider following information:
Cost basis of the asset (I)= Rs. 10,000
Useful life(N) =5 years
Estimated salvage value(SV)= Rs. 773
Calculate annual depreciation and the resulting book values using DB method.
Solution;
The book value at the beginning of the first year is Rs. 10,000
The double declining balance rate (α)= 100% ×2= 40%= 0.4
5
The depreciation deduction for the first year will be = 0.4*10,000= Rs. 4000
The book value at the beginning of the second year is I-D1= 10,000-4,000=
Rs. 6,000
So, depreciation deduction for the second year will be 0.4*6,000 or (40% of
6,000) =Rs. 2400
Book value at the beginning of the third year or end of 2nd year is 6000-
2400= Rs. 3600
IN TABULATED
FORM,
n Bn-1 (Rs.) Dn (Rs.) Bn(Rs.)

1 10000 4000 6000

2 6000 2400 3600

3 3600 1440 2160

4 2160 864 1296

5 1296 518 778= Salvage Value

❖What if at the end, Book value doesn't equal to salvage
value?
➢ When Bn is not equal to S we have to make an adjustment in our
depreciation analysis methods.

Case1: When Bn>S

o When Bn>S, we have not depreciated the entire cost of the asset.
o So, to reduce the book value to salvage value as quick as
possible we have to switch from DB method to SL method at
optimal year.
o Optimal year is that year where depreciation by DB in any year
less than or equal to the depreciation by SL.
 • Q. In previous example, what if SV=Rs.0
Solution,
First, computing the DDB depreciation for each year. (Same
as previous method
n Bn-1(Rs.) Dn(Rs.) Bn(Rs.)

1 10000 4000 6000

2 6000 2400 3600

3 3600 1440 2160

4 2160 864 1296

5 1296 518 778

 HERE, BOOK VALUE AT THE END OF USEFUL LIFE IS
778>0 (I.E.BN>S). SO, ADJUSTING BY SWITCHING IS
REQUIRED.
If switch to straight
line at the begining of
SL depreciation DDB depreciation Decision
(n)
year

1 (10000-0)/5= 2000 <4000 DNS

2 (6000-0)/4= 1500 <2400 DNS

3 (3600-0)/3= 1200 <1440 DNS

4 (2160-0)/2= 1080 <864 Switch to SL

 THE OPTIMAL YEAR IS 4 IN THE SITUATION, SO WE
SWITCH TO SL DEPRECIATION METHOD AFTER 4TH
Finally,
YEAR.
Year DDB with switchto SL(RS.) EOY book value(Rs.)

1 4000 6000

2 2400 3600

3 1440 2160

4 1080 1080

5 1080 0=SV
Case II: when Bn<S
This is the case of over depreciation, which is not permitted by tax
law to depreciate below salvage value, so adjusting is made by
doing Bn=S.
Q. In previous example, let SV= 2000

EOY Dn(Rs.) Bn(Rs.)

1 4000 10000-4000= 6000

2 2400 6000-2400= 3600

3 1440 3600-1440= 2160

4 864>160 2160-160= 2000

5 0 2000-0= 2000
3. SUM OF YEARS DIGIT (SOYD) METHOD

• This method gives larger depreciation charges at the early

year and smaller changes at the end of estimated useful
life as compared to SL method.
Depreciation at each year is calculated as,
Dn= {N−n+1}(I−S)
SOYD

Where, SOYD = 1+2+3+......N= N(N+1)/2

Q. Let, I= Rs. 10000
N= 5 years
SV= Rs. 2000
Soln:
SOYD= 1+2+3+4+5= 15 , So
EOY Dn(Rs.) Bn(Rs.)

1 (5-1+1)/15*(10000-2000)= 2667 10000-2667= 7333

2 (5-2+1)/15*8000= 2133 7333-2133= 5200

3 3/15*8000= 1600 5200-1600= 3600

4 2/15*8000= 1067 3600-1067= 2533

5 1/15*8000= 533 2533-533= 2000 (SV)

 4. SINKING FUND METHOD
• Book value decreases at increasing rates with respect to
the life of the asset.
• The loss by depreciation (cost-salvage) value should be
recovered in the form of sinking fund.
• To understand this, you must have concept about time
value of money.
 Suppose ,

Rs. 20,000

(Inflow)
0 6 8
2 3 4 5 7
1
(outflow)

Rs. 1,00,000
Interest rate (i)= 12%
• Sinking fund is that amount of money to be deposited
annually to replace the initial cost at the end of its useful
life.
For above examples,
Salvage value at the end of useful life= Rs.20000
Total amount required to deposit at the end of useful
life=Rs. 80000
Amount to be deposit= 80000
No. of years= 8 years
Annual deposit = 80000/8= Rs. 10000
WE MUST CONSIDER TIME VALUE OF
MONEY I.E. A= TS(A/F, 12%,8)
=80000(A/F,12%,8)
𝑖
=80000*{ }
(1+𝑖)𝑛−1
0.12
=80000*{ }
(1+0.12) 8 −1
=6504.22
=Rs. 6504
Annual sinking fund = Rs. 6504
• Depreciated amount by sinking fund method at end of each
year is the sum of sinking fund amount and interest on
sinking fund.
20,000
6,504

0 2 4 5 6 7
1 3 8

1,00,000
So, depreciation at the end of first year D1= Rs. 6504
Depreciated sum at EOY, 2nd
D2= 6504+(6504*0.12)= Rs. 7284.48
Similarly,
D3= 6504+(6504+7284.48)*0.12= Rs. 8158.62
D4= 6504+ (6504+7284.48+8158.62)*0.12= Rs. 9137
And so on
FINAL RESULTS OF DEPRECIATION VALUE AND
BOOK VALUE IN TABULATED FORM CAN BE
REPRESENT AS :
EOY Fixed depreciation Net depreciation(D1) (Rs.) Book value
0 6504 0 100000
1 6504 6504 93496
2 6504 7284.48 86211.52
3 6504 8158.62 78052.90
4 6504 9137.65 68915.25
5 6504 10234.17 58681.08
6 6504 11462.07 47218.81
7 6504 12837.74 34381.07
8 6504 14378.27 20002.80
 5. MODIFIED ACCELERATED COST RECOVERY
SYSTEM(MACRS)
• First, estimated standard useful life of assets should be selected
as 3yrs, 5yrs, 7yrs, 10yrs, 15yrs, 20yrs, 27.5yrs &39 yrs.(8
categories).
• Salvage value at the end of useful life is always 0.
• Mostly used for tax purposes.
• It uses half year convention i.e. it is assumed that all assets are
placed in service at mid year & they have zero salvage value.
• Only half year depreciation is allowed for the first year and for the
last year.
• Concept of switching is required to determine depreciated rate.
 Q. IF I=RS 10,000 AND USEFUL LIFE N=5YRS COMPUTE
MACRS PERCENTAGE AND DEPRECIATION AMOUNTS FOR
THE ASSET .
Solution,
Useful life= 5 yrs.
But 1st and last are half year convention i.e.
5 6
0 1 3 4
2

1.5 2.5 3.5 4.5 5.5

0.5

i.e. MACRS deduction percentage beginning with the first taxable year &
ending with 6th year.
STRAIGHT LINE RATE
=1/5= 0.2 DDB RATE=
2*0.2= 0.4 UNDER MACRS,
SV=0 Calculation(%)
Year MACRS% Decision

1 1/2 year DDB= 0.5*0.4*100% 20%

2 DDB dep= 0.4*(100-20)% 32% DNS

SL dep= (100-20)%/4.5 17.78%
3 DDB dep= 0.4*(100-52)% 19.20% DNS
SL dep= (100-52)%/3.5 13.71%
4 DDB dep= 0.4*(100-71.2)% 11.52% Switch to SL
SL dep= (100-71.2)%/2.5 11.52%
5 SL Dep=11.52% 11.52%

6 SL Dep= 0.5*11.52% 5.76%

NOW DEPRECIATION AMOUNTS FROM THE
PERCENTAGES:
Year MACRS(%) Depreciation basis Dn(Rs.)

1 20% 10000 2000

2 32% 10000 3200

3 19.20% 10000 1920

4 11.52% 10000 1152

5 11.52% 10000 1152

6 5.76% 10000 576

CORPORATE TAX
IT IS A DIRECT TAX IMPOSED BY A JURISDICTION ON THE
INCOME OR CAPITAL OF THE CORPORATION. MANY
COUNTRIES IMPOSE SUCH TAXES AT THE NATIONAL
LEVEL, STATE, OR LOCAL LEVEL. IT CAN BE ALSO REFERRED
TO AS CAPITAL TAX OR INCOME TAX.

After tax cash flow analysis

1. Calculate before tax cash flow in year n,
(BTCF)n= Rn-En
Where, Rn= Revenue from the project during year n
En= Expenses of the project during year n
2. Calculate taxable income:
(TI)= Rn-En-Dn
Where, Dn= Depreciation amount at nth year
3. Calculate income tax amount during year n,
Tn= tr(Rn-En-Dn)
Where, Tn= Taxable amount during year n
tr= tax rate
4. Calculate after tax cash flow in year n
(AFTCF)n= BTCFn-Tn
Q. If an organization have annual revenue generation of
Rs. 13000 and operation and maintenance cost is about Rs.
5000 annually. If cost basis of 5 years project is Rs. 50000
then determine after tax cash flow. (Use MACRS method for
depreciation) tax rate= 40%
Here, I= Rs. 50000
N= 5yrs
Rn= Rs. 13000
En= Rs. 5000
 So,
EOY BTCFn MACRS% Dn TI0 tax (ATCF)n

1 4000 20% 10000 0 0 4000

2 8000 32% 16000 0 0 8000

3 8000 19.2% 9600 0 0 8000

4 8000 11.52% 5760 2240 896 7104

5 8000 11.52% 5760 2240 896 7104

6 4000 5.76% 2880 1120 448 3552