Taxes and Depreciation

MACRS
 Review

• What is Depreciation?
– Decline in value due to wear and tear (deterioration),
obsolescence and lower resale value.
• Why do we compute depreciation?
• To reduce net profit before taxes =>Decrease
taxes =>Increase the cash flow after taxes
 Review (cont’d)

• How do you compute Depreciation?

– It is computed separately for each asset.
– It depends on
» 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

• Several depreciation methods exist.

• So-called historical or classical methods
– Straight Line
– Sum of the Years Digits
– Declining Balance
• Current method mandated by the government
– Modified Accelerated Capital Recovery System
(MACRS)
 Method 4: Modified Accelerated
Capital Recovery System (MACRS)
• 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
• Rental property is assigned a 27.5-year tax life
• Nonresidential real property is assigned a 31.5-year tax
life)
 MACRS (cont’d)

• 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)

• 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

• 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 3-year class 5-year class

1 33.33% 20%
2 44.45% 32%
3 14.81% 19.2%
4 7.41% 11.52%
5 11.52%
6 5.76%
 Recall Example 1: Should we invest?

• New Machine:
– 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

Periods Bef ore Tax Depreciat ion Taxable Tax Aft er Tax
Cash Flow Income Cash Flow
0 -1 1 00 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 1 0 00 1 0 00 400 600
Salvage

• At the end of period 5, Book Value= 0

 Economic Analysis for MACRS 3-year

• Before-tax NPW
= -11000 + 3000 (P/A, 0.09, 5) + 1000 (P/F, 0.09, 5)
= 1319
• 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
• Before-tax ROR = 13.34%
• After-tax ROR = 9.45%
 Example 1 with MACRS 5-year
Periods Before Tax Depreciation Taxable Income Tax After Tax
Cash Flow Cash Flow
0 -11000 -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 1000 -267.20 -106.88 1106.88

Salvage

• 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

• After tax NPW = -110

• After tax ROR = 8.61%
 Summary

• 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)

• Investment
– For new assets, there is no tax effect at time
0.
Year BT Cash Depr Taxable –Tax AT Cash

Flow Income Flow

0 -10000 -10000
1 3000 5000 -2000 +800 3800
2 3000 2500 500 -200 2800
3 3000 1250 1750 -700 2300
4 3000 625 2375 -950 2050
4 Sal. 2000 625 1375 -550 1450
 Summary (cont’d)

• Annual Revenues / Operating Cost

– ATCF = BTCF - Tax
– Tax = (BTCF - Depreciation)(tax rate)
Year BT Cash Depr Taxable –Tax AT Cash

Flow Income Flow

0 -10000 -10000
1 3000 5000 -2000 +800 3800
2 3000 2500 500 -200 2800
3 3000 1250 1750 -700 2300
4 3000 625 2375 -950 2050
4 Sal. 2000 625 1375 -550 1450
 Summary (cont’d)

• 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 BT Cash Depr Taxable –Tax AT Cash

Flow Income Flow

0 -10000 -10000
1 3000 5000 -2000 +800 3800
2 3000 2500 500 -200 2800
3 3000 1250 1750 -700 2300
4 3000 625 2375 -950 2050
4 Sal. 2000 625 1375 -550 1450
 What tax rate do we use?

• 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.
• 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.
• If SV > BV then the amount SV - BV is a capital
gain,
– you must pay tax on the capital gain
• 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

• 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