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ENGINEERING ECONOMY Fifth Edition

Mc
Blank and Tarquin Graw
Hill
CHAPTER 17

17.3
EFFECT ON TAXES OF DIFFERENT
DEPRECIATION METHODS AND
RECOVERY PERIODS

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17.3 Criteria for Selection

Given two or more depreciation

(recovery) plans and:
 Constant single value tax rate;
 Same recovery period;
 CFBT > depreciation amount for the given
year;
 The methods reduce the basis to the same
salvage value over the same time period.
Compute the PW (i%) of the future tax
savings for each plan.

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17.3 Multiple Criteria Can Be Used

1. Minimize the present worth at some i
% over n time periods of the tax;
2. Maximize the present worth at some i
% over n time periods of the taxes
saved.
PWTAX is defined by:
n
PWtax   (taxes in year t)(P/F,i%,t) or,
t 1
n
PWtaxes saved   Dt (te )( P / F , i %, t )
t 1
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17.3 Rule:

For depreciation plans over the same

recovery period, and targeting the same
salvage value:
 The total taxes saved are equal for all

depreciation models;
 The present worth of taxes saved is

always less for accelerated

depreciation methods.

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Example 17.4
An after tax analysis of a new $50,000
machine proposed for a fiber optics
manufacturing line is in process. The CFBT for
the machine is estimated at $20,000. If the
recovery period of 5 years applies, use PW of
taxes criterion, an effective tax rate of 35%
and a return of 8% per year to compare the
following:
1- Classical SL 2- Classical DDB
3- Required MACRS depreciation
Use 6 year period to accommodate for half year
convention.

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17.3 The Goal!

If the firm is profitable and the TI

amount is > 0, then:
 Using a depreciation plan that writes off
more of the asset in the early years is
preferred!
 Achieving greater tax savings early on
permits the firm to retain more after-tax
dollars;
 Which can be reinvested at or above the
firm’s MARR!
 Promote future wealth maximization!

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17.3 Comparing Depreciation Plans

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Different recovery Periods

Change only assumption 2 from the

previous case.
The depreciation method applies.
Comparison will indicate:
the total taxes paid are equal for all n
values.
The PW of taxes is less for smaller n
values

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Example 17.5

A diversified manufacturing
corporation maintains parallel records

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ENGINEERING ECONOMY Fifth Edition

M c
Blank and Tarquin Graw
Hill
CHAPTER 17

17.4
DEPRECIATION RECAPTURE AND
CAPITAL GAINS AND LOSSES FOR
CORPORATIONS

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17.4 CAPITAL GAIN OR GAIN ON SALE

Firms sell or dispose of assets from

time to time.
Those assets have been fully
depreciated, or are still being
depreciated for tax purposes.
Assets that are disposed do have a
book value.
 Could be + or,
 Could be “0”.

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17.4 Capital Loss: CL

A capital loss occurs when an

asset is sold for less than its
current book value.
Could generate a tax savings since
the “loss” could be tax deductible
within certain rules.
CL = BVt - SP

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17.4 Gain on Sale (Capital Gain)

Gain on Sale is defined as:

 GS = Selling Price – Current Book Value;
Capital Gain is defined as:
 CG = Selling Price – First Cost.
Certain Assets will gain value over time
and could be sold for more than what
was originally paid for them.
This will generate a tax liability and tax
will have to be paid!

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17.4 Sale of Productive Assets

Confine discussion to the disposal of

productive assets.
The term “Depreciation Recapture”
applies. (DR).
DR = SP – BVt [ 17.12 ]
Three possible outcomes can happen
when a productive asset is disposed at
time t.

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17.4 Disposal – 3 Outcomes

1. The asset is sold for a price > BVt

 SP > BVt generates a tax liability

2. The asset is sold for a price = BVt

 SP = BVt no tax liability generated

3. The asset is sold for a price < BVt

 SP < BVt generates a tax savings

Assume a tax rate – Te applies.

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17.4 Disposal Example

Assume an asset was originally

purchased for $10,000, 3 years ago.
Assume the current book value for tax
purposes is $3,000.
We will apply three different
hypothetical selling prices to see the
various tax implications due to disposal.
Assume a tax rate of 34% applies.

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17.4 Disposal: SP > BVtime of sale

Assume SP = $4,000.
BV = $3,000.
Compute (SP – BV) = (4,000 – 3000).
Equals +$1,000. (Recaptured Depr.)
Gain on Disposal.
Tax Rule: Treated as ordinary income to
the firm and taxed at the tax rate.
Tax: $1,000 (0.34) = $340.00
NCFsale = $1,000 – 340 = $660

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17.4 RD Cases Illustrated

B
Depreciated portions from
which tax savings
have resulted

Current
Book
Value
Undepreciated amount
(investment remaining to be
SV = 0
recovered)

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17.4 RD: SP > BV@ Disposal

Recaptured Depreciation
B Remaining Book Value

Sales Price > BV

Current RD Amt SP > BV
Book
Value
Amt. “over-depreciated:
Recaptured as Ordinary Income:
SV = 0 Taxed @ Ord. Tax Rate

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17.4 Disposal: SP = BVTime of Sale

Assume SP = $3,000.
Compute (SP – BV) = (3,000 – 3,000)
=0
No gain or loss on sale;
No tax implications!
NCFSale = $3,000.
When an asset is disposed of for its
current book value, there is no
recaptured depreciation and no tax.

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17.4 Disposal: SP < BVTime of Sale

Assume SP = $2,000;
BV = $3,000
Compute: (SP – BV) = (2,000 – 3,000)
= -$1,000.
 “Minus” means “loss on disposal”
The loss can be treated as negative
ordinary income and deducted.
Tax: (-1,000)(0.34) = -$340.00
Form of a negative tax!

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17.4 Disposal: SP < BVTime of Sale

Tax: (-1,000)(0.34) = -$340.00

Form of a negative tax!
NCF = SP – Tax;
NCF = $2,000 – (-340) = $2,340!
Treat the tax savings on the loss on
disposal as a positive cash flow.
Assume tax deductibility of the loss
amount, which generates a tax savings.

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17.4 RD: SP < BV@ Disposal

Asset is disposed at below the

B book value, creating a loss on
disposal.

Creates a “loss” on disposal and

Current
is treated as a deduction (tax
Book savings).
Loss On
Value Disposal
Sale Price less than BV
SV = 0

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17.4 Disposal: 4th Situation: SP > B

What if the SP is greater than the

original basis of the asset? (rare for
productive assets)
Assume SP = $12,000;
B = $10,000.
BVtime of sale = $3,000
Two Components to deal with:
 (SP – B) = 12,000 – 10,000 = $2,000
 Called the “Gain” amount

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17.4 Disposal: 4th Situation: SP > B

2nd Component:
 B – BVTime of Sale
 $10,000 - $3,000 = $7,000
Tax Situation for Economy Studies
 Tax the “gain” part at either 34%, or
whatever the current capital gain tax rate is
at the time (28%) on gains.

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17.4 Disposal: 4th Situation: SP > B

Tax the Recaptured Depreciation

amount of $7,000 at the ordinary
income tax rate of 34%.
The RD amount is treated as ordinary
income.
Possible Tax Evaluation assuming the
“gain” part is taxed at 28% and RD at
34%.

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17.4 Disposal: 4th Situation: SP > B

Possible Tax Evaluation assuming the

“gain” part is taxed at 28% and RD at
34%.
 Gain: $2,000 (0.28) = $560
 RD: $7,000 (0.34) = $2,380
 Total Tax: $2,940
 NCF – sale: $12,000 - $2,940 = $9,060

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17.4 Recaptured Depreciation (RD)

Assume case 1:
 SP = $4,000;
 BV = $3,000
Asset is sold for more than its current
book value.
The depreciation plan specified that the
book value is now $3,000.
But a market value is now set at
$4,000.
 (willing buyer and willing seller agreement)

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17.4 RD – Explained

From the tax view:

The asset brought more that its current
book value.
Implication: That the firm over-
depreciated the asset by $1,000 (but
not intentionally!)
The Tax code treats the $1,000 as
ordinary income, or recaptured
deprecation, and taxes it at 34%

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17.4 To Recapture Means…

To treat as ordinary income and pay a

tax on that amount.
Any time an asset is disposed of for an
amount that exceeds the current book
value for tax purposes,
The amount in excess of the current
book value is treated as ordinary income
and taxed as such.

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17.4 “0” Salvage Value Issue

Recall, MACRS assumes a “0” salvage

value for fully depreciated assets.
What if an asset is fully depreciated?
Under MACRS the book value at the
time of disposal will be 0.
IF SP > 0, then the SP amount is also
taxed at the ordinary tax rate!

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17.4 Disposal During the Recovery Period

Under current Federal tax law:

 Any depreciable asset that is disposed of
during the recovery period requires the
following:
1. Only ½ year of the normal depreciation is
permitted in the year of disposal.
2. Assumption: Disposal occurs at the middle
of the year in question.
3. The beginning of year book value is
reduced by the ½ year of recovery to
establish the BV for tax purposes.

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17.4 Disposal During Recovery Year

Assume an asset is in its 4th year of

recovery and is sold (disposed).
Assume the beginning of year book
value is $5,000.
Assume the 4th year’s total recovery –
if not disposed – would be $2,000.
Only ½ year of recovery is permitted
for year 4 or ½ (2,000) = $1,000.

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17.4 Disposal Example – continued

Now, the book value for tax purposes is:

 Beginning of year’s BV3 = $5,000,
 Less the $1,000 of permitted recovery due to
the half-year rule on disposal, or $4,000.
The sale price, SP, is now compared to
the $4,000 BV@ Time of Sale to determine if
there is any recaptured depreciation.

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17.4 Half-Year Rule for Disposal

Assume disposal anytime during year
“t” where “t” is less than or equal to the
MACRS recovery period for the asset.

Mid-Year

Year “t” No Depr. Permitted

B.O.Y.-t E.O.Y.-t

However, the firm is eligible for ½ of the

current year’s MACRS depreciation regardless
of when disposal actually took place in the
year.
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17.4 Depreciation Recapture Concluded

We now expand the TI expression to

accommodate depreciation recapture
amounts.

TI = GI – E – D +DR + CG – CL [17.14]

Applicable only to corporations and not to individuals!

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17.4 Summary for Disposal Analysis

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