ME 314 – MACRS Depreciation and Taxation Example
This guide will illustrate how to solve a problem involving depreciation and income tax. Refer to the included step-by-step instructions and cash flow table to answer a few of the more common questions I’ve heard about this type of analysis.
Example:
A construction company purchases a new heavy truck for $150,000. After operator, insurance, maintenance, and fuel costs are paid, the truck will generate $30,000 of net annual revenue. If the truck is sold after 7 years, will this investment meet the company’s MARR of 8%? Use MACRS depreciation, and assume that the company’s other income is high enough to ensure a 34% tax rate for the truck income.
Solution:
1) Determine before-tax cash flows (BTCF). • Capital costs (i.e, the truck purchase) will be included in year 0. • Salvage value will be included separately from ordinary income in year 7. This becomes important in situations when equipment is not fully depreciated before it is sold or scrapped.
2) Determine depreciation values (dt). • Since we’re using MACRS depreciation, the first step is to determine the appropriate property class for trucks. • • Look in Tables 11.1 and 11.2 to see that trucks and construction equipment are in the 5-year MACRS GDS property class. Now look at Table 11.3 to determine the depreciation schedule for 5-year MACRS property: Year 1 2 3 4 5 6 • rt 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%
To calculate the depreciation (dt) in year t, use the relation dt = B·rt, where B = basis cost (initial book value) = $150,000. (E.g., d1 = $150,000 * 20.00% = $30,000)
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At this point, it’s also helpful to place the final book value of the asset (Bt) in the depreciation column, next to the salvage value. In this example, the truck had depreciated to Bt = $0 by Year 6.
3) Determine taxable income. • Subtract the depreciation value from the before tax cash flow for nonsalvage income in each year. (Taxable income = BTCF−dt) • For income received from the sale of capital goods (i.e., salvage values), subtract the remaining book value from the salvage value received . (Taxable income = SV − Bt) In this example, the year 7 book value (Bt) is $0, so the entire salvage value is counted as taxable income. Note: Taxable income may be negative if depreciation exceeds annual income; however, capital expenditures can not be deducted from gross income in determining capital income because these purchases do not reflect a loss of assets. This is why the Year 0 taxable income is $0, despite the $150,000 purchase. 4) Determine tax. • Multiply taxable income by the tax rate. It is acceptable to round up or down to the nearest dollar. Note: I’ve combined the year 7 amounts at this point for clarity. 5) Determine after-tax cash flow (ATCF). • ATCF = BTCF − Tax • After-tax cash flow may now be treated like the cash flow tables in Chapters 5-7 for the purpose of determining NPW, EUAB/EUAC, IRR/RoR, etc.
6) Calculate net present worth or rate of return. • As with other problems of this type, the investment is acceptable if the NPW > 0 when i = MARR, or if i > MARR when NPW = 0. • NPW solution: PWC = $150,000 PWB = $30,000(1.08)-1 + $36,120(1.08)-2 + … + $33,000(1.08)-7 = $151,939 NPW = PWC −PWB = $1,939 Since the purchase of the truck has a positive NPW when i = 8%, the investment meets the company’s MARR.
Cash Flow Table for MACRS Example
Year BTCF Depreciation Value (dt) -30,000 48,000 28,800 17,280 17,280 8,640 0 0 Taxable Income (BTCF-dt) (SV – Bt) 0 0 -18,000 1,200 12,720 12,720 21,360 30,000 20,000 Tax (34% * Tax. Income) 0 0 -6,120 408 4,325 4,325 7,262 17,000 ATCF (BTCF-Tax) -150,000 30,000 36,120 29,592 25,675 25,675 22,378 33,000
0 1 2 3 4 5 6 7
-150,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 20,000
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