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LESSON 14. Depreciation
LESSON 14. Depreciation
Functional loss: Losses can occur without any physical changes. For
example, a car can lose value over time because styles change so that it is no
longer fashionable. Other examples of causes of loss of value include legislative
changes, such as for pollution control or safety devices, and technical changes.
Functional loss is usually expressed simply in terms of the particular unsatisfied
function.
Value of an Asset
Models of depreciation can be used to estimate the loss in value of an asset over
time, and also to determine the remaining value of the asset at any point in time.
This remaining value has several names, depending on the circumstances.
2. One needs an estimate of the value of owned assets for planning purposes.
In order to decide whether to keep an asset or replace it, you have to be
able to judge how much it is worth. More than that, you have to be able to
assess how much it will be worth at some time in the future.
Purpose of Depreciation
1. Normal Depreciation
Economic Life is the length of time during which the property may be
operated at a profit.
1. It should be simple
2. It should recover capital
3. The book value will be reasonably close to the market value at any
time.
Time-Independent Methods
1. Unit Production Method
2. Working Hours Method
Time-Dependent Methods
1. Straight Line Method
2. Sinking Fund Method
3. Sum-of-years-digits
4. Declining Balance Method
We shall use the following symbols for the different depreciation methods.
FC = First cost
dr = annual depreciation
Example:
A Xerox machine costing P75,000 with a salvage value of P10,000 at the end
of its life can print 3 million sheets in its entire life. If it has already printed
500,000 sheets, find the total depreciation at that time.
Solution:
FC=75,000
= 10,000
0.5M 3M
Dn = FC-SV = 65,000
Dr = P10833.33
2. WORKING HOURS METHOD
Example:
A lathe machine costing 3M has a salvage value of P0.1M at the end of 20
years. It can be used for 5000 hours in its entire life. Find the accumulated
depreciation after using it for 1000 hours.
Solution:
= P2.9M
FC= P3M
= P0.1M
Dr = P0.58M
TIME-DEPENDENT METHODS
Where:
FC = First cost
Dn = total depreciation ant the end of n years
Dr = accumulated depreciation at the end of r
periods.
BVr = Book value at the end of periods.
SV= Salvage Value
d = annual depreciation/depreciation charge
Dn
d=
n
Example:
A company has purchased an equipment whose first cost is
P100,000 with an estimated life of eight years. The estimated salvage
value of the equipment at the end of its lifetime is P20,000. Determine
the depreciation charge and book value at the end of various years
using the straight line method of depreciation.
Solution:
Given: FC = P100,000
SV = P20,000
n = 8 years
Dn = FC-SV = P80,000
𝐃𝐧 𝟖𝟎,𝟎𝟎𝟎
dr= = =P10,000 - Ans. depreciation charge
𝐧 𝟖
In this method of depreciation, the value of d is the same for all the years.
The calculations pertaining to BVr for different values of r are summarized in the
table below.
Where:
FC = First cost
Dn = total accumulated depreciation at the
end of n years
Dr = accumulated depreciation at the end of r
periods.
BVr = Book value at the end of periods.
SV= Salvage Value
d = annual depreciation/depreciation charge
Formula:
(𝟏+𝒊)𝒏−𝟏
Dn = 𝒅 ( )
𝒊
(𝟏+𝒊)𝒓 −𝟏
Dr = 𝒅 ( )
𝒊
Example:
A company has purchased an equipment whose first cost is P100,000 with
an estimated life of eight years. The estimated salvage value of the equipment
at the end of its lifetime is P20,000. Determine the book value of the equipment
after 5 years using Sinking Fund Method. i = 12%
Solution:
Given: FC = P100,000
SV = P20,000 = P80,000
n = 8 years FC= P100,000
r n=8
First, determine depreciation charge:
(1+𝑖)𝑛 −1
Dn = 𝑑 ( )
𝑖
8
(1+0.12) −1
80,000 =𝑑 ( ), d = 6504.23
0.12
It provides very rapid depreciation during the early years of life of the
property, and therefore enables faster recovery of capital.
The basic assumption for this method is that the value of the property
decreases at a decreasing rate.
To compute:
1. List the digits corresponding to the number for each permissible year
of life in reverse order
2. Determine the sum of these digits
3. For any year, the depreciation factor is the number from the
reversed-order listing for that year divided by sum of the digits.
4. The depreciation deduction for any year is the product of the SYD
depreciation factor that year and the difference between the cost
basis/FC and the SV.
Where:
d1 = depreciation charge during first year
only.
d2 = depreciation charge during second
year only.
Formula:
dr = (SYD factor)(Dn) Or
(𝑛−𝑟+1)
dr = 𝐷𝑛
1+2+3…..+𝑛
Example 1:
A new electrical saw for cutting small pieces of lumber in a furniture
manufacturing plant has a cost basis of $4,000 and a 10-year depreciable life.
The estimated SV of the saw is zero at the end of 10 years. Determine the annual
depreciation amounts using the straight-line method. Tabulate the annual
depreciation amounts and the book value of the saw at the end of each year.
Use SYD.
Solution:
(Using table)
1. Find for the depreciation factor each year.
2. Solve for depreciation charge and BV for each year using the formula
Ex: dr = (SYD factor)(Dn), Dn = FC-SV = 4000 – 0 = 4000
10
d1 = (55) (4000) = $ 727.27
9
d2 = ( ) (4000) = $654.55
55
The depreciation and book value amounts for each year are shown below.
EOY, r dr BVr
4. DECLINING BALANCE METHOD (DBM)
It is assumed that the annual cost of depreciation is a fixed percentage of
the BV at the beginning of the year.
The ratio of the depreciation is a fixed percentage of the BV at the
beginning of the year is constant throughout the life of the asset and is
designated by k (0 ≤ k ≤ 1).
The annual depreciation charges, different each year, decrease from
year to year, greatest during the 1st year and least in the last year of life of
the property.
With this method, a property can never depreciate to zero value.
Formula:
BVr = FC(1 − k)𝑟 𝑟 𝐵𝑉𝑟 Where: k = annual rate of
Or 𝑘 =1− depreciation
𝑟 𝐹𝐶
𝑆𝑉 𝑛
BVr = FC (𝐹𝐶 ) Or
Sv = FC(1 − k)𝑛 𝑛 𝑆𝑉
𝑘 = 1−
𝐹𝐶
dr = k FC(1 − k)𝑟−1
Example:
Solution:
FC = P100,000
n = 8 years
k = 0.2
Solving for d1, d2 and d3 using the formula dr = k FC(1 − k)𝑟−1 , we get:
d1 =0.2(100,000)(1-0.2)1-1 = P20,000
d2 = 0.2(100,000)(1-0.2)2-1 = P16,000
d3 = P12,800
Therefore,
D3 = 20,000 + P16,000 + 12,800
D3 = P48,800
BV3 = P51,200
Formula:
Or
Sv = FC(1 − k)𝑛
dr = k FC(1 − k)𝑟−1
Example:
Solution:
𝐹𝐶 = Php 15, 000 𝑆𝑉 = Php 2, 000 𝑛 = 10 r= 8
(a) Declining Balance Method
𝑛 𝑆𝑉 10 𝑃ℎ𝑝 2, 000
k=1− √ =1− √ = 0.1825 or 18.25%
𝐹𝐶 𝑃ℎ𝑝 15, 000
2 8 2 8
𝐵𝑉8 = 𝐹𝐶 (1 − ) = 𝑃ℎ𝑝 15, 000 (1 − ) = 𝑃ℎ𝑝 2, 517
𝑁 10
𝐷8 = 𝐹𝐶− 𝐵𝑉8 = 𝑃ℎ𝑝 15, 000 − 𝑃ℎ𝑝 2, 517 = 𝑃𝒉𝒑 𝟏𝟐, 𝟒𝟖𝟑
AFTER– TAX ECONOMIC ANALYSIS
Income tax is the amount of the payment (taxes) on income or profit that
must be delivered to a federal (or lower-level) government unit. Taxes are real
cash flows; however, for corporations tax computation requires some noncash
elements, such as depreciation. Corporate income taxes are usually submitted
quarterly, and the last payment of the year is submitted with the annual tax return.
The required after-tax MARR is established using the market interest rate,
the corporation’s effective tax rate, and its weighted average cost of capital. The
CFAT (cash flow after taxes) estimates are used to compute the PW or AW at the
after-tax MARR. When positive and negative CFAT values are present, a PW or AW
< 0 indicates the MARR is not met.
Two or more alternatives. Select the alternative with the best (numerically
largest) PW or AW value.
If only cost CFAT amounts are estimated, calculate the after-tax savings
generated by the operating expenses and depreciation. Assign a plus sign to
each saving and apply the guidelines above.
PLAN S PLAN B
4 11, 500
5 10, 600
Solution:
𝑃 𝑃 𝑃
𝐴𝑊𝑆 = [−28, 000 + 5400 ( , 7%, 6) + 2040 ( , 7%, 4) ( , 7%, 6)
𝐴 𝐴 𝐹
𝑃 𝐴
+ 2792 ( , 7%, 10)] ( , 7%, 10)
𝐹 𝑃
AW𝑆 = $ 422
𝑃 𝑃
𝐴𝑊𝐵 = [−50, 000 + 14, 200 ( , 7%, 1) + 13, 300 ( , 7%, 2)
𝐹 𝐹
𝑃 𝑃
+ 12, 400 ( , 7%, 3) + 11, 500 ( , 7%, 4)
𝐹 𝐹
𝑃 𝐴
+ 10, 600( , 7%, 5)] ( , 7%, 5)
𝐹 𝑃
AW𝐵 = $ 327
Both plans are financially viable; select plan S because AW𝑆 is larger
REPLACEMENT STUDY
The need for a replacement study can develop from several sources:
Defender and challenger are the names for two mutually exclusive
alternatives. The defender is the currently installed asset, and the
challenger is the potential replacement. A replacement study compares
these two alternatives. The challenger is the “best” challenger because it
has been selected as the best one to possibly replace the defender. (This is
the same terminology used earlier for incremental ROR and BC analysis, but
both alternatives were new).
Market value is the current value of the installed asset if it were sold
or traded on the open market. Also called trade-in value , this estimate is
obtained from professional appraisers, resellers, or liquidators familiar with
the industry. As in previous chapters, salvage value is the estimated value
at the end of the expected life. In replacement analysis, the salvage value
at the end of one year is used as the market value at the beginning of the
next year.
AW values are used as the primary economic measure of
comparison between the defender and challenger. The term equivalent
uniform annual cost ( EUAC) may be used in lieu of AW, because often only
costs are included in the evaluation; revenues generated by the defender
or challenger are assumed to be equal. (Since EUAC calculations are
exactly the same as for AW, we use the term AW.) Therefore, all values will
be negative when only costs are involved. Salvage or market value is an
exception; it is a cash inflow and carries a plus sign.
Defender first cost is the initial investment amount P used for the
defender. The current market value ( MV ) is the correct estimate to use for
P for the defender in a replacement study. The estimated salvage value at
the end of one year becomes the market value at the beginning of the
next year, provided the estimates remain correct as the years pass. It is
incorrect to use the following as MV for the defender fi rst cost: trade-in
value that does not represent a fair market value , or the depreciated book
value taken from accounting records. If the defender must be upgraded
or augmented to make it equivalent to the challenger (in speed, capacity,
etc.), this cost is added to the MV to obtain the estimated defender fi rst
cost.
Example 4.15
Only 2 years ago, Techtron purchased for $275,000 a fully loaded SCADA
(supervisory control and data acquisition) system including hardware and
software for a processing plant operating on the Houston ship channel. When it
was purchased, a life of 5 years and salvage of 20% of fi rst cost were estimated.
Actual M&O costs have been $25,000 per year, and the book value is $187,000.
There has been a series of insidious malware infections targeting Techtron’s
command and control software, plus next-generation hardware marketed only
recently could greatly reduce the competitiveness of the company in several of
its product lines. Given these factors, the system is likely worth nothing if kept in
use for the fi nal 3 years of its anticipated useful life.
Model K2-A1, a new replacement turnkey system, can be purchased for $300,000
net cash, that is, $400,000 first cost and a $100,000 trade-in for the current system.
A 5-year life, salvage value of 15% of stated first cost or $60,000, and an M&O cost
of $15,000 per year are good estimates for the new system. The current system
was appraised this morning, and a market value of $100,000 was confirmed for
today; however, with the current virus discovery, the appraiser anticipates that
the market value will fall rapidly to the $80,000 range once the virus problem and
new model are publicized.
Using the above values as the best possible today, state the correct defender
and challenger estimates for P, M&O, S, and n in a replacement study to be
performed today.
Solution:
Defender: Use the current market value of $100,000 as the fi rst cost for the
defender. All others—original cost of $275,000, book value of $187,000, and trade-
in value of $100,000—are irrelevant to a replacement study conducted today.
The estimates are as follows:
Challenger: The $400,000 stated first cost is the correct one to use for P, because
the trade-in and market values are equal.
If the replacement study is conducted next week when estimates will have
changed, the defender’s first cost will be $80,000, the new market value
according to the appraiser. The challenger’s first cost will be $380,000, that is, P –
(TIV – MV) = 400,000 – (100,000 – 80,000).
o Performing a Replacement Study
Replacement studies are performed in one of two ways: without a study period
specified or with one defined. Figure 4–4 gives an overview of the approach
taken for each situation. The procedure discussed in this section applies when no
study period (planning horizon) is specified. If a specific number of years is
identified for the replacement study, for example, over the next 5 years, with no
continuation considered after this time period in the economic analysis.
1. On the basis of the better 𝐴𝑊𝐶 or 𝐴𝑊𝐷 value, select the challenger C or
defender D. When the challenger is selected, replace the defender now,
and expect to keep the challenger for 𝑛𝐶 years. This replacement study is
complete. If the defender is selected, plan to retain it for up to 𝑛𝐷 more
years. (This is the leftmost branch of Figure 4–4.) Next year, perform the
following steps.
One-year-later analysis:
2. Determine if all estimates are still current for both alternatives, especially first
cost, market value, and AOC. If not, proceed to step 3. If yes and this is year
𝑛𝐷 , replace the defender. If this is not year 𝑛𝐷 , retain the defender for
another year and repeat this same step. This step may be repeated several
times.
3. Whenever the estimates have changed, update them and determine new
𝐴𝑊𝐶 and 𝐴𝑊𝐷 values. Initiate a new replacement study (step 1).
Figure 4 – 4. Overview of replacement study approaches.
If the defender is selected initially (step 1), estimates may need updating after 1
year of retention (step 2). Possibly there is a new best challenger to compare with
D. Either significant changes in defender estimates or availability of a new
challenger indicates that a new replacement study is to be performed. In
actuality, a replacement study can be performed each year or more frequantly
to determine the advisability of replacing or retaining any defender, provided a
competitive challenger is available.