08/10/2022

Depreciation

Lecture No. 4
Chapter 3
Engineering Economy, 3rd Edition
Hipolito Sta. Maria

What is Depreciation?
• Definition: Loss of value for a fixed asset
between two periods
• Example: Market values of a vehicle over 5 years
End of Market Loss of
Year Value Value
2004 $20,000
14,000 $6,000
Depreciation

2005
2006 10,000 4,000
2007 7,000 3,000
2008 5,000 2,000
4,000 1,000
2009

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Definitions of Value
Value: Present worth of all future profits that are to be
received through ownership of a particular property
Market Value: amount at which a willing buyer will pay to a
willing seller for the property
Fair Value: determined by a disinterested third party in order
to establish a price that is fair to both seller and buyer
Book value: sometimes called depreciated value, is the worth
of the property as shown on the accounting records of an
enterprise
Salvage value; or resale, value is the price that can be
obtained from the sale of a property after it has been used
Scrap Value: the amount of property would sell for if disposed
off as junk

Types of Depreciation

❑ Normal Depreciation
a) Functional
b) Physical
❑Depreciation due to changes in price levels
❑Depletion

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Factors to Consider in Asset

Depreciation

❑ Depreciable life (how long?)

❑ Salvage value (disposal value)

❑ Cost basis (depreciation basis)

❑ Method of depreciation (how?)

What Can Be Depreciated?

✓ Assets used in business or held for production of income

✓ Assets having a definite useful life and a life longer than

one year

✓ Assets that must wear out, become obsolete or lose value

A qualifying asset for depreciation must satisfy all of the three

conditions above.
Note: You never depreciate “land.”

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Physical and Economic Life

❑Physical life of a property is the length
of time during which it is capable of
performing the function for which it
was designed and manufactured.

❑Economic life is the length of time

during which the property may be
operated at a profit.

Purposes of Depreciation

1. To provide for the recovery of capital that has

been invested in physical property.

1. To enable the cost of depreciation to be charged

to the cost of producing products or services
that result from the use of the property.

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Depreciation Methods

L=useful life of the property in years

𝐶𝑜 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡
𝐶𝐿 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑟 𝑠𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
d= annual cost of depreciation
𝐶𝑛 = 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑛 𝑦𝑒𝑎𝑟𝑠
𝐷𝑛 = 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑢𝑝 𝑡𝑜 𝑛 𝑦𝑒𝑎𝑟𝑠

1. Straight Line Method

❑Assumes that the loss in value is
directly proportional to the age of the
property

𝐶0 − 𝐶𝐿
𝑑=
𝐿
𝑛(𝐶0 − 𝐶𝐿 )
𝐷𝑛 =
𝐿
𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

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2. The Sinking Fund Formula

❑Assumes that a sinking fund is established
in which funds will accumulate for
replacement
(𝐶0 −𝐶𝐿 )𝑖
𝑑=
(1 + 𝑖)𝐿 −1
𝑑((1 + 𝑖)𝑛 − 1)
𝐷𝑛 =
𝑖
𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛

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3. Declining Balance Method

❑Sometimes called the constant percentage method or
the Matheson Formula, it is assumed that the annual
cost of depreciation is a fixed percentage of the salvage
value at the beginning of the year.

Let 𝑑𝑛 = depreciation during the nth year

𝑑𝑛 = 𝐶𝑜 (1 − 𝑘)𝑛−1 𝑘 𝑛 𝐶𝑛
𝐶𝑛 = 𝐶𝑜 (1 − 𝑘)𝑛 𝑘 = 1−
𝐶𝑜
𝐶𝐿 𝑛
𝐶𝑛 = 𝐶𝑜 ( )𝐿 𝐿 𝐶𝐿
𝐶𝑜 𝑘 = 1−
𝐶𝐿 = 𝐶𝑜 (1 − 𝑘)𝐿 𝐶𝑜

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4. Double Declining Balance Method

2 2
𝑑𝑛 = 𝐶𝑜 (1 − )𝑛−1
𝐿 𝐿

2
𝐶𝑛 = 𝐶𝑜 (1 − )𝑛
𝐿

2
𝐶𝐿 = 𝐶𝑜 (1 − )𝐿
𝐿

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5. Sum-of-the-Years Method (SYD)

Let 𝑑𝑛 = depreciation during the nth year

𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡
𝑑𝑛 = (𝐶 − 𝐶𝐿 )
𝑠𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 𝑜

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6. Service Output Method

❑Assumes that the total depreciation that has
taken place is directly proportional to the
quantity of output of the property up to that
time
Let T= total units of output up to the end of life
𝑄𝑛 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑛𝑡ℎ 𝑦𝑒𝑎𝑟

𝐶𝑜 −𝐶𝐿
𝑑𝑛 = ( )𝑄𝑛
𝑇

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