Suppose a firm buys a milling machine for $100,000 and uses it for five years, after which it is scrapped. The cost of the goods produced by the machine must include a charge for the machine, and this charge is called depreciation. In the following sections, we review some of the depreciation concepts covered in accounting courses. Companies often calculate depreciation one way when figuring taxes and another way when reporting income to investors: many use the straight-line method for stockholder reporting (or “book” purposes), but they use the fastest rate permitted by law for tax purposes. Under the straight-line method used for stockholder reporting, one normally takes the cost of the asset, subtracts its estimated salvage value, and divides the net amount by the asset’s useful economic life. For an asset with a 5-year life, which costs $100,000 and has a $12,500 salvage value, the annual straight-line depreciation charge is ($100,000 _ $12,500)/5 _ $17,500. Note, however, as we discuss later, that salvage value is not considered for tax depreciation purposes.

For tax purposes, Congress changes the permissible tax depreciation methods from time to time. Prior to 1954, the straight-line method was required for tax purposes, but in 1954 accelerated methods (double-declining balance and sum-of-years’- digits) were permitted. Then, in 1981, the old accelerated methods were replaced by a simpler procedure known as the Accelerated Cost Recovery System (ACRS). The ACRS system was changed again in 1986 as a part of the Tax Reform Act, and it is now known as the Modified Accelerated Cost Recovery System (MACRS); a 1993 tax law made further changes in this area.

Note that U.S. tax laws are very complicated, and in this text we can only provide an overview of MACRS designed to give you a basic understanding of the impact of depreciation on capital budgeting decisions. When dealing with tax depreciation in real-world situations, current Internal Revenue Service (IRS) publications or individuals with expertise in tax matters should be consulted.

Tax Depreciation Life

For tax purposes, the entire cost of an asset is expensed over its depreciable life. Historically, an asset’s depreciable life was set equal to its estimated useful economic life; it was intended that an asset would be fully depreciated at approximately the same time that it reached the end of its useful economic life. However, MACRS totally abandoned that practice and set simple guidelines that created several classes of assets, each with a more-or-less arbitrarily prescribed life called a recovery period or class life. The MACRS class lives bear only a rough relationship to assets’ expected useful economic lives.

A major effect of the MACRS system has been to shorten the depreciable lives of assets, thus giving businesses larger tax deductions early in the assets’ lives, thereby increasing the present value of the cash flows.

Higher depreciation expenses result in lower taxes in the early years, hence a higher present value of cash flows. Therefore, since a firm has the choice of using straight-line rates or the accelerated rate, most elect to use the accelerated rates. The yearly recovery allowance, or depreciation expense, is determined by multiplying each asset’s depreciable basis by the applicable recovery percentage. Calculations are discussed in the following sections.

Half-Year Convention Under MACRS, the assumption is generally made that property is placed in service in the middle of the first year. Thus, for 3-year class life property, the recovery period begins in the middle of the year the asset is placed in service and ends three years later. The effect of the half-year convention is to extend the recovery period out one more year, so 3-year class life property is depreciated over four calendar years, 5-year property is depreciated over six calendar years, and so on.

Depreciable Basis The depreciable basis is a critical element of MACRS because each year’s allowance (depreciation expense) depends jointly on the asset’s depreciable basis and its MACRS class life. The depreciable basis under MACRS is equal to the purchase price of the asset plus any shipping and installation costs. The basis is not adjusted for salvage value (which is the estimated market value of the asset at the end of its useful life) regardless of whether accelerated or straight-line depreciation is taken. Sale of a Depreciable Asset If a depreciable asset is sold, the sale price (actual salvage value) minus the then-existing undepreciated book value is added to operating income and taxed at the firm’s marginal tax rate. For example, suppose a firm buys a 5-year class life asset for $100,000 and sells it at the end of the fourth year for $25,000. The asset’s book value is equal to $100,000(0.11 _ 0.06) _ $100,000(0.17) _ $17,000. Therefore, $25,000 _ $17,000 _ $8,000 is added to the firm’s operating income and is taxed.

Depreciation Illustration Assume that Stango Food Products buys a $150,000 machine that falls into the MACRS 5-year class life and places it into service on March 15, 2003. Stango must pay an additional $30,000 for delivery and installation. Salvage value is not considered, so the machine’s depreciable basis is $180,000. (Delivery and installation charges are included in the depreciable basis rather than expensed in the year incurred.) Each year’s recovery allowance (tax depreciation expense) is determined by multiplying the depreciable basis by the applicable recovery allowance percentage. Thus, the depreciation expense for 2003 is 0.20($180,000) _ $36,000, and for 2004 it is 0.32($180,000) _ $57,600. Similarly, the depreciation expense is $34,200 for 2005, $21,600 for 2006, $19,800 for 2007, and $10,800 for 2008. The total depreciation expense over the six-year recovery period is $180,000, which is equal to the depreciable basis of the machine.

As noted above, most firms use straight-line depreciation for stockholder reporting purposes but MACRS for tax purposes. In this case, for capital budgeting purposes MACRS should be used. In capital budgeting, we are concerned with cash flows, not reported income. Since MACRS depreciation is used for taxes, this type of depreciation must be used to determine the taxes that will be assessed against a particular project. Only if the depreciation method used for tax purposes is also used for capital budgeting analysis will we obtain an accurate cash flow estimate.