Depreciable Basis

CFA Level II Corporate Finance
#1

Schweser says that total depreciation is the same under all methods (just different patterns), but I’m also reading that MACRs ignores salvage value. Does that mean MACRs can go below salvage value, and thus could have higher total depreciation than straight-line or double-declining? That would be contradictory.

Similarly, can someone verify that when factoring depreciation into capital budgeting calculations, salvage value does NOT affect the depreciation numbers? Per this other post, but that’s tricky because it basically changes the formulas. i.e. for cap budgeting purposes , 100k investment with 10k salvage and 5 years life would have 20depr/yr for SL, and 40depr for first year of DD? That would also mean that replacement project net depreciation is not affected by salvage values?

#2

Assuming that the salvage value is the same, total depreciation under all methods will (ultimately) be the same. If you want to compare straight-line or DDB or units-of-activity to MACRS, then you have to use zero for the salvage value.

You should include the salvage value when doing your calculations for capital budgeting, as you will include it when you do the actual depreciation.

#3

It may be semantics, but I agree with Schweser’s statement. MACRS is a tax depreciation method, so I would think of that as a separate case.

#4

Ok thank you for the input! I understand the total depreciation point, but I’m still confused as to if salvage value is used for capital budgeting depreciation. Is this poster incorrect in stating: “dont use salvage value when calculating depreciation in capital budgeting. Salvage value only comes into play in the terminal net operating flow (and also for initial outlay, for replacement projects).”

_ ~Kaplan 2016 Practice Exam Vol 1, Exam 3 Afternoon, Questions 85-90~ _

Henke Malfoy, CFA, is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipmnt. The old machine is still functional and could continue to serve in its current capacity for three more years. If the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000 now but will be worthless in three years. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company’s revenues will increase by $175,000 and costs by $25,000 for each year of the equipment’s 3-year life. There is no expected change in net working capital.

The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of -$62,574

QUESTION1 : The after-tax operating cash flow for the first year of operations with the new equipment (excluding the initial outlay) is closest to:

ANSWER1 : CF1 = (S-C)(1-T)+DT = (175-25)(.6)+(0.4)(.33)(_ 400 _)=$142.8

QUESTION2 : What is the effect of taxes on the operating cash flow in year 2?

ANSWER2 : CF2= -(175-25)(0.4)+_ 400 _(0.45)(0.4)=12

QUESTION3 : The combined after-tax operating cash flow and terminal year after-tax nonoperating cash flow in year 3 is closest to:

ANSWER3 : CF3 = (175-25)(0.6)+(_ 400 _)(0.15)(0.4)=114 TNOCF=Sal+WCInv-T(Sal-B)=10+0-0.4(10-28)=17.2 CF3+TNOCF=131.2

#5

BTW, how do you get 28 as the book value?

#6

Still stumped here. Can anyone shed some light as to why 400 is used for depreciable basis, and also why 28 is used for book value?

#7

Under MACRS Depreciation is calculated as Cost of the Equipment * particular Depreciation for that year. for the next year also cost of equipment is used rather than cost-accumulated dep so that is why 400 is being used. dont know from where 28 comes.

#8

the new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33.0% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e., in three years), Malfoy expects that it can be sold fo r $10,000.

0,07 x 400 = 28

Residual (not yet depreciated amount of BV of asset in year 4) because it will be sold in year 3.

wink

#9

400 is an asset cost so it is used for depreciable basis. 28 is residual asset book value at the end of year 3.

The devil is in details…again.

#10

Ok so MACRS is always cost of equipment in the formula…gotcha.

So SL would have used 400-10=390 as the depreciable basis…and if life = 3 years, then 130 deprec every year. Right?

#11

Yes: you use whatever depreciation method is given.

If straight-line, the salvage value is deducted from the original cost to get the depreciable value, and that is divided by the useful life to get the annual depreciation.

If DDB, twice the annual straight-line rate is multiplied by the beginning book value to get the annual depreciation; this value must be checked to make sure that it doesn’t take you below the salvage value.

If units-of-activity, the salvage value is deducted from the original cost to get the depreciable value; that value is multiplied by the annual units divided by the total expected units to get the annual depreciation.

If MACRS, the scheduled percentage is multiplied by the original cost to get the annual depreciation.