Engineering Economy and

Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Introduction
Depreciation System in Turkey
Other Depreciation Methods
Tax Concepts
After-Tax CF
Effect of Interest on Borrowed Money
Disposition of Depreciable Property
Investment Tax Credit
After-Tax Analyses under Inflation
Content
Chapter 6: Depreciation
6. 1
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Depreciation is the decrease in value of most property with use
and time.
Law permits a deduction of a reasonable allowance for the
exhaustion and wear and tear of property used in trade or
business or of property held for the production of income.
This amount depends on several factors, such as: cost basis or
investment in the property, property class or estimated useful
life, method of depreciation used.
Depreciable property meets the following requirements:
1. It must be used in business or held for production of income.
2. It must have a useful life that can be determined and its useful
life must be longer than 1 year.
Introduction
Chapter 6: Depreciation
6. 2
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
3. It must be something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
Depreciable property may be tangible or intangible:
Tangible property: can be seen or touched
Intangible property: such as copyright or franchise
Tangible property - personal prop.: machinery or equipment
- real prop. : land and generally anything
that is erected on, growing on or attached
to land
Recovery property: tangible depreciable property
Cost basis: taxpayers investment, usually includes cost of
additions to that property (such as installation) also known as
unadjusted basis.
Introduction
Chapter 6: Depreciation
6. 3
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Cost basis less capital recovered, such as depreciation
allowances, is known as unrecovered investment, adjusted
basis or more often, book value.
Recovery period: time over which the cost basis can be
recovered. Usually shorter than inherent physical life of asset.
Introduction
Chapter 6: Depreciation
6. 4
Depreciation System In Turkey
Similar to MACRS (Modified Accelerated Cost Recovery
System) is used. Taxpayers who are required to prepare Balance
Sheet may elect either Straight Line Method or Declining
Balance Method. The others have to use Straight Line Method.
In the case of using SLD method, taxpayers deduce a fixed
percentage (not more than 20%) of their initial cost from the
value of their property every year.
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
In the case of using DBD method, depreciation allowance is
calculated as a fixed percentage of the adjusted basis. This
percentage is twice as much as SLD percentage (not to be more
than 40%). Depreciation period is the same as that of SLD.
The adjusted basis remaining at the end of the depreciation
period is deduced to get 0 salvage.
In the case DBD method is used it can be switched to SLD. The
optimum year is when the the straight-line depreciation first
exceeds the DBD allowance.
Straight-Line Depreciation
Provides for the uniform write-off of an asset. The depreciation
allowed at the end of each year t is equal throughout the
Depreciation System In Turkey
Chapter 6: Depreciation
6. 5
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
propertys depreciation period and is given by:
Declining Balance Depreciation
Depreciation allowed at the end of each year t, is a constant
fraction p of the unrecovered investment at the end of the
previous year.
Depreciation System In Turkey
Chapter 6: Depreciation
6. 6
t
n
P
- P B
: t EOY at basis) d (unadjuste t investnmen d Unrecovere
period on depreciati n
rate/year on depreciati
n
1

n
P
D
t
t
=
=
= =
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
According to Turkish Legislation (J uly 1995):
Law allows to switch to SLD whenever SLD on the
unrecovered portion of the asset exceeds the declining balance
allowance:
Depreciation System In Turkey
Chapter 6: Depreciation
6. 7
1 - n n
1 - n
n
t
t
1 t
t 1 - t t
B B
n
2
1
n
P 2
D
: allowance s year' Last
n
2
- 1 P B
n
2
1
n
P 2
D B
n
2
D
n
2
p
= +
|
.
|

\
|
=
|
.
|

\
|
=
|
.
|

\
|
= = =

1 - t
1 - t
B
n
2
1) - (t - n
B
i.e. )
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Depreciation methods studied so far are tied to the passage of
time. Occasionally, however, recovery of cost over time would
have little relation to an assets use or its production of income.
Therefore taxpayers may be allowed to utilise other consistent
methods of depreciation. Some recognised methods are given
below.
Units of Production Method
Allows equal depreciation per each unit of output, regardless of
the lapse of time involved.
Other Depreciation Methods
Chapter 6: Depreciation
6. 8
asset of life during produced be
to expected units of no. total U
year t in produced units U
U
U
P D
t
t
t
=
= =
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Suitable for depreciating equipment used in mining, oil and gas
production, forest products industry.
Operating Day (hour) Method
suitable for construction equipment such as excavators, dozers,
etc.
Income Forecast Method
Applicable to depreciate cost of rented property such as video
tapes, sound recordings, motion picture films, etc.
Other Depreciation Methods
Chapter 6: Depreciation
6. 9
asset of life during produced
be to expected units of no. total Q
year t during used (hours) days Q
Q
Q
P D
t
t
t
=
= =
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Tax Concepts
Taxes paid represent a real cost of doing business and affect CF
profile; hence, it is wise to perform economic analyses on an
after-tax basis.
Although numerous kinds of taxes (property, sales excise, etc.)
exists, we will mainly consider income taxes (corporate or
personal) in economic analyses.
Other Depreciation Methods
Chapter 6: Depreciation
6. 10
income life useful total R
year t in income rental R
R
R
P D
t
t
t
=
= =
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Income taxes are assessed on gross income less certain
allowable deductions, incurred both in the normal course of
business as well as on gains resulting from the disposal of
property.
Gross income: income less any monies specifically exempt
from tax liability.
Taxable income: gross income less allowable deductions.
Corporate deductions: salaries, wages, repairs, rent, bad debts,
taxes (other than income), charitable contributions, casualty
losses, interest and depreciation.
We can control interest and depreciation to some extent through
financing arrangements and accounting procedures.
Tax Concepts
Chapter 6: Depreciation
6. 11
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
After-Tax CF is the amount remaining after income taxes and
deductions, including interest but excluding depreciation
allowance, are subtracted from gross income.
Before-Tax CF is used when no borrowed money involves, and
it equals gross income less deductions, not including
depreciation.
Before -Tax CF and loan CF is used when borrowed money is
involved, and it equals gross income less deductions not
including either depreciation or principal or interest on loan.
After-Tax CF
Chapter 6: Depreciation
6. 12
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Example 6.1
A company is purchasing a stand-alone computer with
color graphics display, printer, plotter and interfacing
equipment. First cost including installation will be
400B TL with an estimated salvage value of 25B TL at
the end of a projected useful life of 6 years. Find the
permissible depreciation allowances using SLD, DBD
and DBD switchible to SLD methods depreciated at
highest allowable rate (i.e. 20%).
After Tax Cash Flows
Chapter 6: Depreciation
6. 13
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
After Tax Cash Flows
Chapter 6: Depreciation
6. 14
Deductions, D
t
Unrecovered basis, B
t
EOY SLD DBD DBD-SLD SLD DBD DBD-SLD
0 - - - 400B 400B 400B
1 80B 160B 160B 320B 240B 240B
2 80B 96B 96B 240B 144B 144B
3 80B 57.6B 57.6B 160B 86.4B 86.4B
4 80B 34.6B 43.2B 80B 51.8B 43.2B
5 80B 51.8B 43.2B 0 0 0
6 - - - - - -
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
After Tax Cash Flows
Chapter 6: Depreciation
6. 15
Check for the year when
1
1
2
) 1 (

)

t
t
B
n t n
B
At EOY2:
240/4 = 60B TL < 0.4 x 240 = 96B TL
At EOY3:
144/3 = 48B TL < 0.4 x 144 = 67.6B TL
At EOY4:
86.4/2 = 43.2B TL > 0.4 x 86.4 = 34.56B TL
Therefore, switch to SLD EOY4
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Note here that neither the estimated salvage value nor the
projected useful life are involved at this point. The actual SV
should be accounted for as will be illustrated later. Also note that
DBD and DBD-SLD both gave the same result for the example.
Example 6.2
Assume that the computer of the above example is expected to
reduce operating expenses by 120B TL each year. Therefore
Before-Tax CF will increase by 120B TL during each year of the
computers useful life. Find After-tax CFs using SLD and
DBD. Then apply the PW method as an effectiveness measure to
see whether the alternative to purchase the computer yields at
least 15% after-tax rate of return. Take corporate income tax rate
as 35%.
After Tax Cash Flows
Chapter 6: Depreciation
6. 16
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
After Tax Cash Flows
Chapter 6: Depreciation
6. 17
Depreciation All.,
D
t
, B TL
Taxable income,
BTL
Tax at 35%, B TL
After Tax CF,
B TL
EOY
t
Before
Tax CF
B TL SLD DBD DBD-
SLD
SLD DBD DBD-
SLD
SLD DBD DBD-
SLD
SLD DBD DBD-
SLD
0 -400 - - - - - - - - - - - -
1 120 80 160 160 40 -40 -40 14 -14 -14 106 134 134
2 120 80 96 96 40 24 24 14 8.4 8.4 106 111.6 111.6
3 120 80 57.6 57.6 40 62.4 62.4 14 21.84 21.84 106 98.16 98.16
4 120 80 34.6 43.2 40 85.4 76.8 14 29.89 26.88 106 90.11 93.12
5 120 80 51.8 43.2 40 68.4 76.8 14 23.94 26.88 106 96.06 93.12
6 120 - - - 120 120 120 42 42 42 78 78 78
6 25 (SV) - - - 25 25 25 8.75 8.75 8.75 16.25 16.25 16.25
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
SLD:
3.7845 3.3522 0.4323
PW(15) = - 400 + 78(P/A 15,6) + 28(P/A 15,5) +16.25(P/F 15,6)
= - 3,922,525,000 TL
DBD:
0.4323 0.4972 0.5718
PW(15) = - 400 + (78 + 16.25)(P/F 15,6) + 96.06(P/F 15,5) +90.11(P/F 15,4)
0.6575 0.7561 0.8696
+ 98.06(P/F 15, 3) +111(P/F 15, 2) + 134(P/F 15, 1)
= 6,582,165,000 TL
DBD-SLD:
PW(15) = - 400 + 94.25x0.4323+93.12(0.4972 + 0.5718) + 98.16x0.6575
+ 111.6x0.7561 + 134x0.8696
= 6,841,515,000 TL
After Tax Cash Flows
Chapter 6: Depreciation
6. 18
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Effect of Interest on Borrowed
Money
Chapter 6: Depreciation
6. 19
If an investment is partially or fully financed using debt
(borrowed) funds, borrowed amount, including both principal
and interest, must be repaid.
Interest repaid each year affects taxable income and hence,
taxes.
Both principal and interest payments affect after-tax CF.
There re four common ways of payment:
a) Periodic payment of interest over stipulated repayment period
with entire principal being repaid t the end of the time.
b) Periodic payment that uniformly repays principal and also
covers periodic interest. Payments decrease as interest on unpaid
principal decreases.
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Effect of Interest on Borrowed
Money
Chapter 6: Depreciation
6. 20
c) Uniform periodic payment for the sum of principal plus
interest. The proportion of principal gradually increases as the
proportion of interest decreases.
d) Both principal and interest are paid at the end of a specified
period.
Example 6.3
Assume that a business borrows 100B TL to be used in financing
an alternative, and the interest rate on this loan is 18%
compounded annually. The stipulated repayment period is 4 years.
All relevant components of this example are given in the
following table.
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Chapter 6: Depreciation
6. 21
EOY Int. due
BTL
Balance before
paym. BTL
Int.
paym.
Princ.
paym.
Total
paym.
Balance after
paym. BTL
0 - - - - - 100
1 18 118 18 0 18 100
2 18 118 18 0 18 100
3 18 118 18 0 18 100
M1
4 18 118 18 100 118 0
0 - - - - - 100
1 18 118 18 25 43 75
2 13.5 88.5 13.5 25 38.5 50
3 9 59 9 25 34 25
M2
4 4.5 29.5 4.5 25 29.5 0
0 - - - - - 100
1 18 118 18 19.17 37.17 80.83
2 14.55 95.38 14.55 22.62 37.17 58.21
3 10.48 68.69 10.48 26.69 37.17 31.52
M3
4 5.67 37.17 5.67 31.52 37.17 0
0 - - - - - 100
1 18 118 0 0 0 118
2 21.24 139.24 0 0 0 139.24
3 25.06 164.30 0 0 0 164.30
M4
4 29.58 193.88 93.88 100 193.88 0
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Effect of Interest on Borrowed
Money
Chapter 6: Depreciation
6. 22
Interest on borrowed money is deductible for tax purposes,
whereas the principal repayment does not enter into taxable
income
Both interest and principal portions of a payment are real and
must be taken into account in calculating CFs.
Example 6.4
Let us assume that 100B TL of 400B TL paid for the computer of
the previous example is through the debt funding. The loan is to
be repaid using two different plans (plans 3 and 4) at 18% over 4
years. The remaining 300B TL will be equity money. The
resulting after CF profile can be found using the previously
obtained results as shown in the following table.
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Effect of Interest on Borrowed Money
Chapter 6: Depreciation
LOAN PLAN 3 LOAN PLAN 4
EOY
t
Before
Tax and
loan CF
B TL
DBD-
SLD
Allow.
Loan
Princ.
Paym.
Loan
Int.
Paym.
Taxable
Income
Taxes After
Tax
CF
Loan
Princ.
Paym.
Loan
Int.
Paym
.
Taxable
Income
Taxes After
Tax
CF
0 -400 - -100 - - - -300 -100 - - - -300
1 120 160 19.17 18 -58 -20.3 103.13 0 0 -40 -14 134
2 120 96 22.62 14.55 9.45 3.31 79.52 0 0 24 8.4 111.6
3 120 57.6 26.69 10.48 51.92 18.17 64.66 0 0 62.4 21.84 98.16
4 120 43.2 31.52 5.67 71.13 24.90 57.91 100 93.88 -17.08 -5.98 -67.90
5 120 43.2 - - 76.80 26.88 93.12 - - 76.80 26.88 93.12
6 120 - - - 120 42 78 - - 120 42 78
6 25 (SV) - - - 25 8.75 16.25 - - 25 8.75 16.25
6. 23
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
PLAN 3:
0.8696 0.7561 0.6575
PW(15) = - 300 +103.13(P/F 15,1) + 79.52(P/F 15,2) +64.66(P/F 15,3)
0.5718 0.4972 94.25 0.4323
+57.9(P/F 15,4) + 93.12(P/F 15,5) +(78+16.25)(P/F 15,6)
= 12,471,629,000 TL
PLAN 4:
PW(15) = - 300 + 134x0.8696 + 111.60x0.7561 + 98.16x0.6575
- 67.90x0.5718 + 93.12x0.4972 + 94.24x0.4323
= 13,665,679,000 TL
After Tax Cash Flows
Chapter 6: Depreciation
6. 24
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
MARR=15% is an after-tax rate of return.
Cost of capital (after-tax interest rate) = 18%(1-tax rate)
= 18(1-0.35) = 11.7%
Desirability of borrowed funds depends on the terms of the
loan, including the method of repayment, interest and
repayment period.
Disposition of Depreciable Property
A disposition is the permanent withdrawal of property from
use in trade or business or in the production of income.
Effect of Interest on Borrowed
Money
Chapter 6: Depreciation
6.25
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
A withdrawal may be made by sale, exchange, retirement,
abandonment, or destruction.
When property is disposed off, a gain occurs if the selling
price exceeds the unrecovered investment, adjusted basis, or
book value of the asset. If the opposite is true, the result is a
loss.
All gain on the disposition of tangible property, other than
residential rental or non-residential real, is treated as ordinary
income so long as it does not exceed the total depreciation
taken on the asset. This is called depreciation recapture.
Disposition of Depreciable
Property
Chapter 6: Depreciation
6.26
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
Gains can be carried forward up to 3 years. If within those
years there is an investment activity towards the renewal of
that property, it can be treated as a source for that investment.
Losses can be carried forward to offset positive tax liabilities.
Investment Tax Credit
This may be designed to stimulate investment by providing
reduced taxation in the years in which investment is realised.
This credit can only be applied on the equity capital of an
investment.
Disposition of Depreciable
Property
Chapter 6: Depreciation
6.27
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443
2009 Fall
The equity spent for an investment each year can be deducted
from the income tax. If the income of a particular year is not
sufficient for such a deduction, this amount can be carried
forward until the total equity is deducted.
After-Tax Analyses Under Inflation
Two procedures may be used:
1. Express all CFs in terms of their then-current amounts and
use an interest rate (i) that combines the real discount rate (d)
and the inflation rate (j): i = d + j + dj
2. Express all CFs in terms of their constant worth amounts
and use the real discount rate (d) alone without an inflation
rate component.
Investment Tax Credit
Chapter 6: Depreciation
6.28