DEPRECIATION &

AFTER TAX ANALYSIS

Engineering Economy
Saturday, May 22, 2021
Corporation cash flow diagram
Dividends to Income from Patents,
Stockholders Engineering, R&D, etc
Borrowed capital R&D
Equity capital
Outside investments
Cash flow Corporation
cash

Working capital Direct investment

Sales revenue Operating costs

Operations
Gross profit
Depreciation
Amortization
Depletion
Deferred deduction
Taxable income
Net profit INCOME TAX
 NET CASH FLOW – NCF
► NCF represents:
§ Cash Inflow – Cash Outflows for a given time
period.
► From economy studies the engineer will
estimate the future net cash flows
associated with the project over its
estimated life.
► Now, we define Cash Flow Before Tax
(CFBT).
 Cash Flows Before Tax (CFBT)
► CFBT:
§ Actual real cash flows associated with an
investment BEFORE any income tax
considerations are applied.
§ CFBT does not consider depreciation or
depletion amounts.
► Next, CFBT will be defined.
 CFBT Defined
► CFBT =
§ Gross income – expenses – initial
investment + salvage value
§ CFBT= GI – E – P + S [17.7]
§ Note:
►Depreciation and depletion amounts are not
part of CFBT as they are not real cash flows
per se.
Important Terms: Gross Income
► Gross Income
§ Total income for the tax year from all revenue-
producing functions of the enterprise.
►Sales revenues,
►Fees,
►Rent,
►Royalties,
►Sale of assets
 Cash Flow After Tax ( CFAT)
► CFAT for a given time period is defined as:
§ CFAT = CFBT – Taxes.
§ The “Taxes” component must be expanded to
include the impacts of depreciation and or
depletion.
§ Depreciation is a noncash flow, but is deductible
from GI and serves to moderate (lessen) the TI
amount.
 Expanding the CFAT Amount
► Specifically:
§ CFAT = GI – E – P + S –(GI-E-D)(TE)
§ Note the (GI-E-D)(Te) term.
§ (GI – E – D) represent the taxable income
component;
§ Multiplying (GI – E – D) by Te computes
the tax on the taxable income part.
§ Then the tax is subtracted from the CFBT
to yield the CFAT amounts.
 Depreciation – Definition
► Depreciationis the reduction of an asset’s
value over time.
► Brought on by:
§ Wear and tear, use;
§ Deterioration;
§ Obsolescence.
► Other definitions follow:
 Depreciation–Definition
► Depreciation – Original Reason:
§ Purely economic!
► Economic View:
§ Depreciation represents a “ratable” using up of
devaluation of a productive asset.
§ The asset must have a finite life span that can
be reasonably estimated.
§ Depreciation represents a proper charge against
future income produced by the asset in
question.
 Depreciation and Depletion
► Depreciation provides for the retirement of
a productive asset;
► Depletion provides for the use of a natural
resource;
► Amortization recognizes a prepaid expense
for tax purposes.
 Tax Equation

Tax. Income = Gross Income – {Real

Expenses + Interest Paid +
Depreciation + Amortization +
Depletion + Deferred deduction}
All of the above amounts EXCEPT
depreciation amounts and depletion amounts
are real cash flow to the firm.
 Income Tax
► The total amount of money transferred from
the enterprise to the various taxing agencies
for a given tax year.
§ This tax is based upon the income-producing
power of the firm.
 Operating Expenses (E)
► All legally recognized costs associated with
doing business for the tax year.
§ Real Cash Flows,
§ Tax deductible for corporations,
►Wages and salaries,
►Utilities,
►Other taxes,
►Material expenses,
►Etc.
 Taxable Income (TI)
► Calculated amount of money for a specified
time period from which the tax liability is
determined.
► Calculated as:
§ TI = Gross Income – expenses – depreciation
§ TI = GI – E – D [17.1]
 Tax Rate T
►A percentage or decimal equivalent of TI.
► For Federal corporate income tax T is
represented by a series of tax rates.
► The applicable tax rate depends upon the
total amount of TI.
► Taxes owed equals:
§ Taxes = (taxable income) x (applicable rate)
= (TI)(T). [17.2]
 Net Profit After Tax (NPAT)
► Amount of money remaining each year
when income taxes are subtracted from
taxable income.
► NPAT = TI – {(TI)(T)},
= (TI)(1-T). [17.3]
 NPAT
► Net profits (if positive) represent funds that
are the claim of the owners of the firm –
NOT the firm!
► NPAT can be:
§ “Saved” by the firm,
§ Reinvested within the firm,
§ Paid out as dividends to the stockholders,
§ Some combination of paying dividends and
reinvesting.
 Tax Bracket Description
►A “tax bracket” system is termed a
“graduated tax system.”
► Additional amounts of taxable income are
taxed at the associated bracket tax rate.
 Depreciation Amounts
► Depreciation amounts represent a prorated
amount per year that can be treated as an
“expense” (deduction), but is not a real cash flow.
► Depreciation amounts represent a form of tax
savings to the profitable firm.
► Assume a tax rate of, say, 30%.
► For every $1 of eligible deductions the resultant
tax savings is:
§ (0.30)($1.00) = $0.30.
§ $1 of additional deductions saves the firm $0.30.
 Types of Depreciation
► Book Depreciation
§ Used by a firm for internal financial and
managerial management.
► Tax Depreciation
§ Used by a firm for state and federal income tax
reporting.
§ Follows strict rules and regulations.
 Book Value of an Asset
► Book value:
§ Accounting Term,
§ Reflects the undepreciated (value) on the firm’s
books at a given point in time.
§ May or may not reflect the true market value of
the asset at a point in time.
§ Market value of an asset is what a willing
buyer and willing seller agree to consummate a
sale or exchange.
 Depreciation Models
► Basic (traditional) models are:
§ Straight-Line Method (SL),
§ Sum-of-the-Years Digits Method (SYD),
§ Declining Balance Method (DB).
§ Today, the MACRS Method (a form of declining
balance-modified) – applied in US
 Depreciation calculation
► Book value = Cost - Depreciation charges

P
Cost

Total Depreciation
Money

Charges
Salvage
value
0 1 2 3 4 5
Useful life
Years
 Straight Line Depreciation
1
Annual depreciation charge = (P - S)
N
P = Cost of the asset; S = Salvage value; N = Useful life

Example: P
$ 900
Consider the following 166
- Cost of the asset $ 900
166
- Useful life (in years) 5
- Salvage value $ 70
Money
166
Compute the straight line
166
depreciation value?
166
Annual depreciation charge 70
1
= (900 - 70) = 166 0 1 2 3 4 5
5
Time (Years)
 Straight Line Depreciation
j
Book value @ the end of jth year = P - (P - S)
N

From the previous example:

What would be the book value at the end of three years?

Book value @ the end of 3rd year = $900 - 3 (900 - 70)

5
= $ 402
 16.2 Straight-Line Method
► Compute the Basis minus the estimated
salvage value and divide by n

Dt = ( B - S )d [16.1
]

B-S
Dt = [16.2
]
n
Blank & Tarquin: 5th edition. Ch.16 27
Authored by Dr. Don Smith, Texas
A&M University
 16.2 SL Example
► B = $50,000;
► “n” = 5 years;
► S = $10,000 at t = 5;
► Dt for each year is:
§ ($50,000 - $10,000)/5 = $8,000/year

Blank & Tarquin: 5th edition. Ch.16 28

Authored by Dr. Don Smith, Texas
A&M University
 16.2 SL Example: Tabulation
t Dt BVt

1 $8,000 $42,000

2 8,000 34,000

3 8,000 26,000

4 8,000 18,000

5 8,000 10,000

Blank & Tarquin: 5th edition. Ch.16 29

Authored by Dr. Don Smith, Texas
A&M University
 16.2 Plot of the Straight-Line
Book Value

Blank & Tarquin: 5th edition. Ch.16 30

Authored by Dr. Don Smith, Texas
A&M University
 16.2 SL Observations
► The SL method starts at B and directly
targets “S” n time periods from the present.
► The Depreciation amounts are all equal
($8,000 in this case).
► The book values decline at the same rate
down to $10,000.

Blank & Tarquin: 5th edition. Ch.16 31

Authored by Dr. Don Smith, Texas
A&M University
 16.3 Declining Balance Method
(DB)
► DB is an accelerated depreciation method;
► Provides greater depreciation amounts in
the early time periods over the SL method.
► Is more complex that the SL method.
► Requires assuming a DB rate – normally
taken to equal 2 x SL rate.

Blank & Tarquin: 5th edition. Ch.16 32

Authored by Dr. Don Smith, Texas
A&M University
 16.3 DB Rate
► Given the DB rate,
§ Dt for year t is found by multiplying the
beginning of time period book value by the rate.
► The maximum DB rate set by law is:
§ dMAX = 2(1/n), or twice what the straight rate would be.

Blank & Tarquin: 5th edition. Ch.16 33

Authored by Dr. Don Smith, Texas
A&M University
 16.3 DB Equations
Depr. For year “t”

Dt = (d ) BVt -1 [16.5
]

t -1
dt = (d ) B(1 - d )
Dt= Depreciation year t
d = depreciation rate
BV = book value year t-1

Blank & Tarquin: 5th edition. Ch.16 34

Authored by Dr. Don Smith, Texas
A&M University
 16.3 DB if BVt-1 Not Known
► If BV at the end of the preceding year is not
known, then apply:
t -1
t D = (d ) B(1 - d ) [16.7
]

Blank & Tarquin: 5th edition. Ch.16 35

Authored by Dr. Don Smith, Texas
A&M University
 16.3 Implied SV for DB
Depreciation
► Permissible range for d is:
0 < d < (2/n)
► To force a prescribed salvage value – S
apply:
§ Implied d = 1 – (S/B)1/n [16.11]

Blank & Tarquin: 5th edition. Ch.16 36

Authored by Dr. Don Smith, Texas
A&M University
 16.3 Example 16.3
► B = $80,000;
► n = 10 years;
► S = $10,000;
► Apply the DB and DDB methods to
compute the depreciation amounts and
associated BV’s.

Blank & Tarquin: 5th edition. Ch.16 37

Authored by Dr. Don Smith, Texas
A&M University
 16.3 Example 16.3 DB approach
► The DB method first computes the implied
salvage value from:
§ d = 1 – (10,000/80,000)1/10 = 0.1877
§ d = 18.77% will target the $10,000 SV at
t = 10.
► See Table 16-1 on page 515.

Blank & Tarquin: 5th edition. Ch.16 38

Authored by Dr. Don Smith, Texas
A&M University
 16.3 Spreadsheet Model for Ex. 16.3

Blank & Tarquin: 5th edition. Ch.16 39

Authored by Dr. Don Smith, Texas
A&M University
 DEPLETION
► Depreciation or cost recovery is applied to
assets that can be replaced.
► Depletion applies to resources that are not
easily replaced, like:
§ Timber,
§ Mineral deposits,
§ Oil and gas,
§ Etc.
 DEPLETION: Two Types
► Cost Depletion
§ Called “factor depletion”;
§ Based upon the level of activity or usage;
§ Time is not involved.
► Percentage Depletion
§ Applies a constant, stated percentage of the
resource's gross income provided it does not
exceed 50% of the firm’s current taxable
income.
 Personal vs. Corporate Income
► Individuals report total income;
► Gross earned income;
► However, individuals may not deduct most
of their day-to-day living and working
expenses.
► Individuals must apply the various standard
or itemized deductions permitted by current
law.
► Corporations deduct actual cash-flow
expenses.
 Personal vs. Corporate
► Individuals have to file as either:
§ Single,
§ Married,
§ Head of household.
► Corporations have no such filing status
other than filing as a corporation.
 CFBT: Format

►A tabular approach is suggested.

►Numerous formats exist and no one
single format or design is “the best.”
►Suggested tabular format follows.
BTCF Format with Example 17.3
Life 6
Discount Rate 15.00%
(Signed) (+) (+) or (-) Calculated
Time Gross Operating Investment CFBT
Period Income Expenses or Salvage
0 -$550,000 -$550,000
1 $200,000 $90,000 $110,000
2 $200,000 $90,000 $110,000
3 $200,000 $90,000 $110,000
4 $200,000 $90,000 $110,000
5 $200,000 $90,000 $110,000
6 $200,000 $90,000 $150,000 $260,000
$1,200,000 $540,000 -$400,000 $260,000
NPV Amt ($68,857.76)
IROR 10.751%
 ATCF Format: Example 17.3
Tax Rate: 35.00% Discount Rate Atax 10.00%
(1) (2) (3) (4)
CF(Signed) CF(+) CF(+) or (-) Non-CF
Time Gross Operating Investment Depreciation
Period Income Expenses or Salvage Amt (+) values
0 $0 $0 -$550,000
1 $200,000 $90,000 $0 $110,000
2 $200,000 $90,000 $0 $176,000
3 $200,000 $90,000 $0 $105,600
4 $200,000 $90,000 $0 $63,360
5 $200,000 $90,000 $0 $63,360
6 $200,000 $90,000 $150,000 $31,680
$1,200,000 $540,000 -$400,000 $550,000

First four columns are presented…..

ATCF Format: Example 17.3
(5) (6) (7)
Intermed. Cal. (-) C.F Calculated CF
Taxable Taxes CFAT t
Income (TI)
-$550,000 0
$0 $0 $110,000 1
-$66,000 -$23,100 $133,100 2
$4,400 $1,540 $108,460 3
$46,640 $16,324 $93,676 4
$46,640 $16,324 $93,676 5
$78,320 $27,412 $232,588 6
$38,500 $221,500
NPV -$5,075.14
IROR 9.708%
Last four columns are presented…..
ATCF Amounts from Column 7
(7)
Calculated CF These amounts represent
the after-tax cash flow
CFAT t
values for years 0–6.
-$550,000 0 The analyst can calculate
$110,000 1 PW, FW, AW, IROR, etc.
$133,100 2 using the methods in the
$108,460 3 previous chapters.
$93,676 4 The Goal: Is this
$93,676 5 investment acceptable?
$232,588 6
$221,500
 ATCF Calculations
► Best performed with a spreadsheet model
as shown.
► Depreciation amounts can be calculated in
another spreadsheet and copied (values
only) into the ATCF worksheet.
► User inputs besides the CF values are the
discount rate and the tax rate.
 After-Tax Cash Flow Evaluation
► Assuming the analyst has estimated all
relevant cash flows and conducted an
ATCF analysis, the economic desirability of
the cash flow can be determined.
► All techniques previously presented can be
used, e.g.,
§ Present Worth,
§ Future Worth,
§ Annual Worth,
§ IROR, . . .
Single Project or Multiple Alternatives

► Single Project:
§ PW or AW > 0 at i% or,
§ IROR > i%.
► Two or More Alternatives:
§ Select the alternative with the largest PW or AW
value at the i% rate.
§ If using IROR, must apply the incremental
analysis approach.
 Analysis Techniques
► All previous rules apply:
§ For PW – equal lives
§ For AW – repeatability assumption applies
► Some ATCF problems involve only costs.
► Calculate the after-tax savings generated by
operating expenses and depreciation and
attach a positive sign to the savings.
 Bottom Line
► Allpreviously described analysis methods
can apply to the evaluation of an after-tax
cash flow.
► Unlike previous chapters where the cash
flow was provided, one must first construct
the ATCF from a problem specification, then
apply the analysis approaches.