MIT Civil Engineering 1.011 -- Project Evaluation Spring Term 2003Carl D. Martland Page 11.011 Project EvaluationTAXES & DEPRECIATIONC.D. Martland1. Depreciation2. Taxes3. After-tax cash flowsWhy Worry About Taxes & Depreciation?Income taxes are large cash flows that cannot be ignoredTax credits and depreciation rules are sometimes used to encourage investments and we need to understand how that worksDepreciation is a non-cash expense that results in reduced tax paymentsAfter tax results are most meaningful to companiesA VERY General PerspectiveGross Income (i.e. Revenue) - Expenses - Depreciation= Taxable Income (Net Income Before Taxes) - Income Tax = Net Income After Taxes (i.e. Profit)ROI = Net Income After Tax/(Invest-Deprec)Accounting rules and tax law determine exactlyhow depreciation and taxes affect cash flows.Depreciation Is an Accounting Mechanism to Transform Investment into Annual ExpensesInvestment is a CASH FLOW but not an EXPENSE"Expenses" are, in accounting terms, amounts that can be deducted from current income to calculate profitInvestments simply transform financial assets into another type of capital assetAfter making an investment, you presumably have the same capital value you started withDepreciation is an EXPENSE but not a CASH FLOWDepreciation is an ACCOUNTING means of reflecting the consumption of a capital asset as it is used Possible Ways to View DepreciationAn Engineering Estimate of the decline in capability or loss of value in an asset over timeUse engineering science to determine rate of depreciation (a truck's life is 10 years or 300,000 miles) An Accounting Convention that translates investment expense into reasonable approximations of actual deterioration or lifeUse simplified estimates of lives that reflect actual experience (trucks last 10 years, buildings last 30)A Policy Tool to promote investmentAllow shorter lives for depreciating housing for the elderly to promote private investmentDepreciation RulesThe rules will affect profits, net investment (i.e. investment - depreciation), and ROIChanges in the rules can therefore change the value of the company or of a project!What can be depreciatedTangible or intangible assest that areAre used to produce incomeHave a finite, determinable life > 1 yearDeteriorates from use, natural causes or obsolescenceAre neither inventory nor stock-in-tradeBuildings, machinery, vehicles, computers, ...MIT Civil Engineering 1.011 -- Project Evaluation Spring Term 2003Carl D. Martland Page 2Cash Flow vs. Accounting Expense:Accounting Affects the Cash Flows, NPV, etc.Year-120-100-80-60-40-20020Before Tax Cash FlowYear-12-10-8-6-4-202Depreciation ExpenseDepreciation12345678910-120-100-80-60-40-20020Investment or ExpenseInvestmentTax SavingsDepreciation012345678910Year-120-100-80-60-40-20020After Tax Cash FlowCash FlowMethods of Depreciation:Policy ConcernsSimplicityEngineering formulations can be advanced, but they are complicated for everyone involvedIRS and companies prefer simplicity to realismPromote investment by increasing the NPV of the tax breakShorter asset lifeGreater depreciation in early yearsSelected Methods of DepreciationStraight-lineEqual depreciation per year over life of assetDeclining balance or Sum-of-the-years-digitsMore rapid depreciation in early yearsModified Accelerated Cost Recovery System (MACRS)A limited number of options for useful lifeSimplify book-keeping Straight Line Depreciationdk = (B - S)/Ndk= Deprec. year kB = Cost BasisS = salvage valueN = lifeBook value year k = B - k*dkSalvage012345678910Year012345ThousandsBook Value & DepreciationDepreciation Book ValueDeclining Balance Depreciationd1= B*Rdk = B*(1-R)k-1*RB = Cost BasisBVk= B*(1-R)k BVN= B*(1-R)NSalvage value is not included directlyR = 1/N is straight lineR= 2/N is double declining balance012345678910Year012345ThousandsDepreciationDepreciation Book ValueDeclining Balance Depreciation with Switchover to Straight-Line MethodStart with double declining balanceCalculate the annual depreciation for the remaining balance using straight-line method (for the current book value and the remaining life)Switch to straight line when that method gives more depreciation012345678910Year012345ThousandsDepreciation & Book ValueDepreciation Book ValueMIT Civil Engineering 1.011 -- Project Evaluation Spring Term 2003Carl D. Martland Page 3Conventions to Simplify and Unify Depreciation: MACRSModified Accelerated Cost Recovery System introduced by Tax Reform Act of 1986Salvage Value assumed to be 0More depreciation, less record-keepingUseful life specified by tax code - one of six categoriesShorter lives, fewer categories, & specified annual percentages ORADS (alternative depreciation system), which is straight-line and used for some assetsFirst and last year assumed to be exactly 6 months Don't bother with actual datesTaxesBefore Tax Cash Flows+ tax credits - state income tax - fed. income tax = After Tax Cash FlowsTax Credits: directly offset tax paymentsIncome Tax: proportional to incomeFederal rate (FR): typically 34% for large UScorporationsState rate (SR): typically 6-12% (and deductiblefrom federal taxEffective income tax rate = SR + FR(1-SR) Example: Eff Inc tax rate = .1+.34*.9 = .406After tax MARR = MARR * (1 - eff inc tax rate)Not exact because timing and amount ofincomevary with depreciation and purchase and disposal of assets.After Tax MARRDepreciation & Taxes: SummaryDepreciation and taxes are important because they affect cash flowsDepreciation is based upon accounting rules and the tax code - NOT upon actual physical deteriorationAccelerated depreciation increase expenses and reduces profit in the early years of a project, but actually increases tax flow by reducing taxesTax credits are equivalent to a reduction in the investmentThe after tax MARR is approximately equal to the pretax rate multiplied by (1 - eff inc tax