Lecture 34 35

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
16.3 DB Equations Depr. For year “t”
Dt = (d ) BVt −1 [16.5]
t −1
dt = (d ) B (1 − d ) [16.6]
Depr. Rate
Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University 1
16.3 DB if BVt-1 Not Known

If BV at the end of the preceding
year is not known, then apply:
t −1
Dt = (d ) B (1 − d ) [16.7]
16.3 DB: Book Value Determination
BVt can be determined in two ways:

 1. Using the rate d and the basis, B or,
 2. Subtracting the current year’s
depreciation from the previous year’s
book value.
BVt from d and B:
 Apply:
BVt = B (1 − d ) t
[16.8]
BVt = BVt −1 − D [16.9]
16.3 DB: Implied Salvage Value

Note: From equations 16.4 – 16.9 there is
no mention of the salvage value – S!
DB does not directly use the estimated
salvage value.
DB has its own implied salvage value.
The pure DB method will never depreciate
an asset down to a 0 salvage value unless
you solve for a d rate
( Eq. 16.11).
16.3 DB: Implied Salvage Value
The implied salvage value built

into the DB method is:
S = BVn = B(1 − d ) n
[16.9]
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]
16.3 DB rate – d
By law, the maximum rate for DB is

specified to =:
 Twice the SL rate for a given n.
 This is called “The Double Declining
Balance Rate.”
 If d = 1.5 (SL rate), it is termed the
150% DB rate.
 d can never exceed 2(1/n), but can be
less!
16.3 Excel DB Functions
Excel supports the DB approach as

a single cell function:
Use:
 DDB(B,S,n,t,d) as a cell function.
 “d” argument can be omitted: If so, a

“d” of 2 is assumed by Excel.
Excel also supports a “DB”
function.
 Suggest one avoid using this one as
special care must be taken! DB(B,S,n,t)
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 539
Equations 16.5 and 16.9 are used
to find Dt and BVt
16.1 The Half-Year Convention
During a tax year, assets are

purchased and installed throughout
the first year.
Under current federal tax law the
first year is handled using the half-
year convention.
16.1 The Half-Year Convention
The half-year convention assumes

that assets are placed in service or
disposed off in midyear, regardless of
when these events actually occur
during the year.
This convention is utilized in this text
and in most U.S.-approved tax-
depreciation methods.
There are also mid-quarter and mid-
month conventions.
ENGINEERING ECONOMY Fifth Edition Mc

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CHAPTER 16
16.4
MODIFIED ACCELERATED COST
RECOVERY SYSTEM
(MACRS)
16.4 MACRS Method
MACRS was derived from the 1981

ACRS system and went into effect
in 1986.
Defines statutory recovery
(depreciation) percentages.
Percentages were derived from the
DB method with a switch to SL at
the optimal time and,
Incorporates the half-year
convention.
16.4 MACRS Salvage Value
The MACRS approach assumes a

salvage value of “0” even though
that might not be the case!
16.4 MACRS Actual Depreciation
Depreciation for year “t” is:

 Dt = dt(B)
[16.12]
 dt = a depreciation rate (per cent)
applicable for the t-th year.
 The dt’s are published percentage
rates and cannot be changed.
16.4 MACRS Book Values
MACRS book values are

determined from:
 BV = BV – D [16.13]
t t-1 t
 Or,
 BVt = Basis – sum of accumulated
depreciation.
j =t
BVt = B − ∑ D j [16.14]
j =1
16.4 Observations
Under MACRS:
 The entire Basis (B) is fully depreciated
(recovered) over a specified number of
years (recovery periods).
 A “0” salvage value is, by law, a
functional part of the MACRS system.
 In reality, there may be a positive, “0”,
or negative salvage value at some
point in time.
 Adjustments will have to be made at
that time. (Disposal Analysis)
16.4 MACRS Recovery Periods
For Personal Property the following

MACRS recovery periods apply:
 3- years,
 5-years,
 7-years,
 10-years,
 15-years and,
 20-years.
Six Property Classes for Personal
Property – mid-year convention applies.
16.4 MACRS Personal Property Recovery

Rates
Year-t 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year
1 0.3333 0.2000 0.1429 0.1000 0.0500 0.0375
2 0.4445 0.3200 0.2449 0.1800 0.0950 0.0722
3 0.1481 0.1920 0.1749 0.1440 0.0855 0.0668
4 0.0741 0.1152 0.1249 0.1152 0.0770 0.0618
5 0.1152 0.0893 0.0922 0.0693 0.0571
6 0.0576 0.0892 0.0737 0.0623 0.0529
7 0.0893 0.0655 0.0590 0.0489
8 0.0446 0.0655 0.0590 0.0452
9 0.0656 0.0591 0.0446
10 0.0655 0.0590 0.0446
11 0.0328 0.0591 0.0446
12 0.0590 0.0446
13 0.0591 0.0446
14 0.0590 0.0446
15 0.0591 0.0446
16 0.0295 0.0446
17 0.0446
18 0.0446
19 0.0446
20 0.0446
21 0.0223
1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
16.4 Real Property Classes
Real Property – buildings,

structures, residential rental and
non-residential office-factory types:
 27.5 years for residential rental
property;
 39 years for all other properties.
 Published percentages prorated by
months of the year the property is
placed in service.
 Assumes a mid-month convention.
16.4 39-Year Depreciation Rates
Straight-Line Method for n = 39.

d = 1/39 = 0.02564 or 2.564% per
year;
Except in year 1 and in year 40
where technical adjustments are
made in the percentages.
16.4 Nominal Recovery Periods
3- year property is really recovered

over 4 years;
5-year property is really recovered
over 6 years;
And so forth for each of the other
classes.
16.4 n+1 Rule
The actual recovery of a given

class life assumes a half-year
convention.
That is, it is assumed by law that
an asset is placed in-service at the
middle of the first year.
It does not matter when it is
actually placed in-service;
So, only a ½ year of recovery is
permitted in the first year.
16.4 n+1 Explained
By law, ½ year of recovery is

permitted in the first year and,
The remaining recovery is spread
out over n additional years.
16.4 Derivation of the 3-Year MACRS

Rates
For recovery periods of 3,5,7, and 10

years, the 200% DB with a switch to
straight line is imposed.
For n = 3, the straight-line rate is 1/3.
Twice the straight-line rate is 2(1/3) or
2/3. (0.6667)
Assume a basis of $1.00 for simplicity;
Let the original basis at time t = 0 =
1.000.
16.4 3-Year analysis: First Year
B = 1.000
DDB rate = 0.6667;
But only ½ year in year 1 is
permitted by law so,
d1 = 0.6667/2 = 0.3333;
D1 = (0.3333)(1) = 33.33%
BV1 = 1 – 0.3333 = 0.6667
remaining at the end of year 1.
16.4 Year 2
BV at the end of year 1: 0.6667B;
To be recovered over 3 years.
Rate for year 2 is (from DDB)
 0.6667(0.6667) = 0.4445 or 44.45%
 So, d2 = 44.45% and,
 D2 = 44.45% of B.
 BV2 = BV1 – D2 = 0.6667B – 0.4445B;
 BV2 = 0.2222B ( 2 years remaining to
recover).
16.4 Year 3: Should one switch to SL?

BV2 = 0.2222B;
SL amount over 2 years would be:
 0.2222/2 = 0.1111 for each year;
What is the MACRS deduction for year 3 if DDB is
applied?
 D3 = 0.6667(0.2222B) = 0.1481 or 14.81% of B
 Which is greater for year 3?
 11.11% by switching or,
 14.81% by staying with DDB?
 Ans: Go with the 14.81% …greater than
11.11%
16.4 Year 4
Take the 14.81% of the Basis for

year 3;
Book value at the end of year 3 will be BV2 –
D3 = 0.2222B - .1481B = 0.0741B.
If BV3 = 0.0741B and there is only one more
year remaining, then to achieve a “0”
salvage value at the end of year 4 we take
d4 = 0.0741 – we are done!
16.4 Completed MACRS 3-Year Rates

t dt BVt
1 0.3333 0.6667B
2 0.4445 0.2222B
3 0.1481 0.0741B
4 0.0741 0
1.0000

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CHAPTER 16
16.5
DETERMINING THE MACRS
RECOVERY PERIOD
16.5 MACRS Recovery Periods
For book depreciation one should

use a life the best reflects the
anticipated or expected useful life.
For tax depreciation one generally
wants as short as possible recovery
period to generate more immediate
tax savings.
For book depreciation use whatever
life best defines the usage rate of
the asset.
16.5 MACRS Recovery Lives
For Federal tax purposes, the proper

recovery life is found from IRS
publications (Pub 946).
Table 16-4 illustrated general asset
descriptions and their respective
MACRS recovery periods permitted
by law.
These breakdowns are termed
Property Classes.
16.5 Property Classes – Examples
3-Year Property:
 Special manufacturing and handling
devices, tractors and racehorses.
5-Year Property:
 Computers and peripherals,
 Duplicating equipment.
 Automobiles, trucks, buses,
 Cargo containers,
 Some manufacturing equipment.
16.5 Property Class Examples
7-Year Property Class:

 Office furniture,
 Some manufacturing equipment,
 Railroad cars, engines and tracks,
 Agricultural machinery,
 Petroleum equipment and natural gas
equipment,
 All property not in another class!
The 7-year class is the ‘default’
class!
16.5 MACRS Recovery Lives
10-Year Class:
 Water transportation equipment,
 Petroleum refining,
 Agricultural processing equipment,
 Durable goods manufacturing
equipment,
 Ship building.
16.5 Property Classes – continued
15-Year Class:
 Land improvements,
 Landscaping,
 Pipelines,
 Nuclear power production equipment,
 Telephone distribution and switching
equipment.
20-Year Class:
 Municipal sewers, (developers)
 Farm buildings,
 Telephone switching equipment,
 Power production equipment,
 Water utilities equipment.
27.5-Year Property: (Real Property)

 Residential rental property (homes and
mobile homes).
39-Year Property (Real Property)
 Nonresidential real property attached to
the land, but NOT the land itself.
16.5 The Alternate Depreciation

System
Alternate Depreciation System –

ADS.
It is a modified form of the MACRS
system.
Applies a straight-line approach
with the half-year convention.
Generally used by small or growing
firms that do not have sufficient
taxable income now and in the
immediate future.
16.5 ADS: Overview: 5-Year Example
ADS applies a form of the straight-

line method with the half-year
convention.
Assume 5-Year Property Class;
 “n” = 5;
 1/n = 0.20 per year except in the first
year and in the last year (n=6)
 Year 1: d1 = ½(0.20) = 0.10 or 10% of B
 Years 2-5 = 0.20 or 20% of B;
 Remaining amount – 10% flows over to
the last year, t = 6.
16.5 ADS: 5-Year Rates Tabulated

“t” dt BVt
1 0.10 0.90B
2 0.20 0.70B
3 0.20 0.50B
4 0.20 0.30B
5 0.20 0.10B
6 0.10 0
1.00
16.5 ADS: Reason For

The ADS is available to smaller firms or firms
that are just starting up.
Some firms may not be generating sufficient
profits to take advantage of the more
accelerated depreciation rates that the
MACRS-GDS provides.
Thus, if GDS is elected, the firm may be losing
deductions in the early years.
ADS provides some relief for firms in this
situation.
16.5 ADS: Election
For both the ADS and the GDS:

 For a given tax year the firm elects
either the:
 ADS system for all assets placed in
service for the current tax year or,
 The GDS (accelerated method) for all
assets placed in service for the
current tax year.
The firm cannot mix ADS with GDS
within the tax year! (It must be one
or the other.)
16.5 ADS – GDS:
In engineering economy analysis of

industrial projects:
 Most analysis will be accomplished
using the GDS – accelerated
depreciation rates.

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CHAPTER 16
16.6
DEPLETION METHODS
16.6 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.
16.6 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.
16.6 DEPLETION: Cost Depletion

First, the cost basis of the resource is
determined – first cost or investment cost.
Second, one must estimate the amount of
the resource that is available for
extraction.
 Termed: Resource Capacity.
 It is an estimated value since it is impossible to
predict exactly the true resource capacity!
Then, cost depletion factor pt for year t is
calculated…
16.6 DEPLETION: Cost Depletion Factor
Let t denote the year;

pt denotes the depletion factor for
year t.
Then, pt is defined as:
first cost
pt = [16.15]
resource capacity
16.6 DEPLETION: Cost Method Example
Example 16.5, page 547

Company buys rights to cut timber
for $700,000 at time t = 0.
Estimated 350 million board feet
that can be harvested.
 This is important: A realistic estimate
of the resource must be accomplished
up front!
 Re-estimates can be made in the future
and adjustments made.
16.6 DEPLETION: Important Issue
Major Point for Depletion:

 There must be a reasonable estimate
of the amount of the resource that is
being extracted.
For firms engaged in extraction
activities the process of resource
estimation is an important activity
and requires expert analysis.
16.6 DEPLETION: Example 16.5
Determine the cost depletion amount

for the first two years of harvesting
if:
 Year 1: Harvest 15 million bdft and,
 Year 2: Harvest 22 million bdft.
Compute pt as:
 pt = ($700,000)/350 m-bdft = $2,000/m-
bdft.
 Deplt=1 = 15m-bdft($2,000) = $30,000.
 Deplt=2 = 22m-bdft($2,000) = $44,000.
Year 1 depletion allowance = $30,000

Year 2 depletion allowance = $44,000
For year 1 the $30,000 can be treated
as a deduction from gross income so
long as the depletion amount does not
exceed the first cost of the resource.
Likewise, $44,000 can be deducted
from year 2’s Gross Income.
16.6 DEPLETION – Example
For the first 2 years the recovery

is:
 Year 1:
 $700,000 - $30,000 = $670,000 left to
recover:
 Year 2:
 $670,000 - $44,000 = $626,000 left
to recover.
This process continues as long as
the original estimate applies.
16.6 DEPLETION – Example
Original Estimate – 350 m-bdft

After years 1 and 2, 37 m-bdft have
been extracted, leaving an estimated:
 350 – 37 = 313 m-bdft of the resource left.
This process continues until the
original $700,000 investment is
written off, or….
A revised estimate of the resource is
made.
16.6 DEPLETION: Revision of the

Resource
Assume at the end of year 2 the

resource capacity is re-estimated.
Assume the re-estimate reveals
that there is 450 m-bdft remaining
to start year 3.
Revision of the factor is now
necessary.
Remember, $626,000 remains from
the initial investment of $700,000.
16.6 DEPLETION – Revision for Year 3

on
Cost basis for year 3 is $626,000

New pt is calculated as:
 pt = $626,000/413 = $1,516/M-bdft.
 For years 3 on the $1,516/m-bdft is applied to
calculate the depletion allowance.
 Use this factor until the $700,000 investment is
fully written off, or another re-estimation is
conducted.
 The process stops when the $700,000 is “0”.
16.6 DEPLETION: Percentage Depletion
Percentage depletion uses IRS-

mandated percentages for classes
of resources.
The depletion allowance for this
method cannot exceed 50% of the
firm’s taxable income before the
depletion allowance is claimed.
Percent Depletion =
 Percentage (gross income from
activity)
16.6 DEPLETION: Percent Method

Deposit Percentage
Sulfur, uranium, lead,
nickel, zinc,
22%
Gold, silver, copper,
iron ore, and
geothermal deposits 15%
Oil and gas wells 15%
Coal, lignite, sodium 10%
chloride
Gravel, sand, peat, 5%
stone
Most other minerals 14%
16.6 DEPLETION: Percent Method
Warning:
 These percents change over time due
to changes in the tax law.
 If you are involved in extraction
industry analysis you must keep up
with the current regulations and
percents for this method!
16.6 DEPLETION
See Example 16.6 on page 524.

Gold mine purchased for $10
million.
Estimated gross income for years 1-
5 of $5.0 million and $3.0 million
after year 5.
Depletion charges cannot exceed
50% of taxable income in any given
year (by current tax law).
For gold, the rate is 15%/year.

Years 1–5:
 (0.15)(5.0 million) = $750,000/year
Years 5 on…
 (0.15)(3.0 million) = $450,000/year
First 5 years:
 Write-off = (5)($750,000) = $3.75 million
 There is $10 million - $3.75 m = $6.25 m left.
Years 6 on…
 5 + 6.25 m/$450,000 = 5 + 13.9 = 19 years
 The $10 m is fully recovered after 19 years.
16.6 Depletion Law Requirement
The depletion allowance can be

determined using either the cost or the
percentage method.
The current law requires:
 Cost depletion can be used IF the
percentage depletion is smaller in any year.
 This means that one should apply both
methods in the beginning.
16.6 Depletion Law Requirement
Calculate both amounts:

 Cost Depletion ($-Depl)
 And percentage Depletion (%-Depl)
 Then apply the following rule each year:
%Depl if %Depl ≥ $Depl 

Annual Depletion =  
$Depl if %Depl p $Depl 

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CHAPTER 16
Chapter Summary
16 Summary
Depreciation may be determined for

internal company records (book
depreciation), or for income tax
purposes (tax depreciation).
In the U.S., the MACRS method is the
only one allowed for tax depreciation.
Depreciation does not result in actual
cash flows directly; rather, tax savings
are the result of depreciation.
16 Summary
It is a book method by which the

capital investment in tangible
property is recovered.
The annual depreciation amount is
tax deductible, which can result in
actual cash flow changes.
16 Summary: Straight-Line
Depreciation
It writes off capital investment

linearly over n years. The
estimated salvage value is always
considered.
This is the classical,
nonaccelerated depreciation model.
Simple to apply and is a popular
method for computing book
depreciation.
16 Summary: Declining Balance
The model accelerates

depreciation compared to straight
line.
The book value is reduced each
year by a fixed percentage.
The most used rate is twice the SL
rate, which is called double
declining balance (DDB).
16 Summary: Declining Balance

It has an implied salvage that may be
lower than the estimated salvage.
It is not an approved tax depreciation
method in the U.S.
It is frequently used for book
depreciation purposes.
It may not target a specified salvage
value.
MACRS applies a modification of this
method to determine MACRS recovery
percents.
16 Summary: MACRS
It is the only approved tax

depreciation system in the United
States. It automatically switches
from DDB or DB to SL depreciation.
It always depreciates to zero; that
is, it assumes S = 0. Recovery
periods are specified by property
classes. Depreciation rates are
tabulated.
16 Summary: MACRS
The actual recovery period is 1

year longer due to the imposed
half-year convention.
MACRS alternate straight-line
depreciation is an option, and is
generally used by firms that are
growing and would be wasting
MACRS- accelerated depreciation
amounts.
16 Summary: Depletion
Depletion methods are used to recover
investment in the extraction or harvesting
of natural resources.
Two Methods:
 Cost Depletion,
 Percentage Depletion.
Specific rules apply to both methods.
 Normally, one would calculate depletion
allowances by both methods, then apply the IRS-
mandated permission rules.

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CHAPTER 16
End of Slide Set

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16.3 DB Equations Depr. For year “t”

16.3 DB if BVt-1 Not Known

16.3 DB: Book Value Determination

BVt can be determined in two ways:

BVt = BVt −1 − D [16.9]

16.3 DB: Implied Salvage Value

16.3 DB: Implied Salvage Value

The implied salvage value built

16.3 Implied SV for DB Depreciation

Permissible range for d is:

By law, the maximum rate for DB is

16.3 Excel DB Functions

Excel supports the DB approach as

 “d” argument can be omitted: If so, a

16.3 Example 16.3 DB approach

The DB method first computes the

16.1 The Half-Year Convention

During a tax year, assets are

16.1 The Half-Year Convention

The half-year convention assumes

ENGINEERING ECONOMY Fifth Edition Mc

16.4 MACRS Method

MACRS was derived from the 1981

16.4 MACRS Salvage Value

The MACRS approach assumes a

16.4 MACRS Actual Depreciation

Depreciation for year “t” is:

16.4 MACRS Book Values

MACRS book values are

16.4 MACRS Recovery Periods

For Personal Property the following

16.4 MACRS Personal Property Recovery

16.4 Real Property Classes

Real Property – buildings,

16.4 39-Year Depreciation Rates

Straight-Line Method for n = 39.

16.4 Nominal Recovery Periods

3- year property is really recovered

16.4 n+1 Rule

The actual recovery of a given

16.4 n+1 Explained

By law, ½ year of recovery is

16.4 Derivation of the 3-Year MACRS

For recovery periods of 3,5,7, and 10

16.4 3-Year analysis: First Year

16.4 Year 3: Should one switch to SL?

Take the 14.81% of the Basis for

16.4 Completed MACRS 3-Year Rates

ENGINEERING ECONOMY Fifth Edition Mc

16.5 MACRS Recovery Periods

For book depreciation one should

16.5 MACRS Recovery Lives

For Federal tax purposes, the proper

16.5 Property Classes – Examples

16.5 Property Class Examples

7-Year Property Class:

16.5 MACRS Recovery Lives

16.5 Property Classes – continued

16.5 Property Classes – continued

16.5 Property Classes – continued

27.5-Year Property: (Real Property)

16.5 The Alternate Depreciation