Income Tax

Engineering Economy
Topic 4
Tax & Depreciation
Lecture 8
1
Muniba Sana Younis 12/27/2018
Learning Objectives
 Understand basic terms of asset depreciation

 Apply straight line method of depreciation
 Apply DB and DDB methods of depreciation;
 Apply Units of production method of depreciation
 Apply Sum-of-Years Digits method of depreciation
 Explain depletion and apply cost depletion & percentage
depletion method
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Introduction
 Engineering projects often involve

investment in equipment or other assets.
These assets lose value, or depreciate, over
time.
 But what is Depreciation?
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Definition
Depreciation is the decrease in value of physical properties

with the passage of time and use.
 It is to be specific an accounting concept that establishes

an annual deduction against before-tax income such that
effect of time and use on an asset’s value can be
reflected in a firm’s financial statement.
 Why do we compute depreciation?

 To reduce net profit before taxes =>Decrease taxes
=>Increase the cash flow after taxes
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Depreciation
• Definition: Loss of value for a fixed asset
• Example: You purchased a car worth $15,000 at the
beginning of year 2000.
End of Market Loss of
p
Year Value Value
0 $15,000
Depreciation
1 10,000 $5,000
2 8,000 2,000
3 6,000 2,000
4 5,000 1,000
5 4,000 1,000

Why Do We Need to Consider
Depreciation?
Gross Income -Expenses:

Business (Cost of goods sold)
(Depreciation)
Expense: (operating expenses)
Depreciation is
Taxable Income
viewed as part
of business - Income taxes
expenses that
Net income (profit)
reduce taxable
income.

Example 8-1
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Reasons of Depreciation
Assets depreciate for a variety of reasons:
 Use related physical loss, e.g. tire wear on a car. This

type of loss is usually measured as a function of units of
production, miles driven, or other measures of use.
 Time related physical loss: e.g., rusting of cars. This type

of loss is usually measured in units of time.
 Functional loss : e.g., style changes, changes in safety

device requirements. This is usually measured in terms
of the function lost.
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What Can Be Depreciated?
• Assets used in business or held for production of

income
• Assets having a definite useful life and a life longer than

one year
• Assets that must wear out, become obsolete or lose

value
A qualifying asset for depreciation must satisfy all of the

three conditions above. Can you depreciate land?
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What cannot be depreciated?
Property placed into service and disposed of in the same
year.
Land (land can never be depreciated)
Inventory – You cannot depreciate property held for

resale in the normal course of business
Leased property – The value of the lease is already

showing up as a rental expense
Raised Market Livestock (Because there is no cost to

recover)
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Depreciation Concept
Economic Depreciation
 Purchase Price – Market Value

 (Economic loss due to both physical
deterioration and technological
obsolescence)
Accounting Depreciation
 A systematic allocation of cost basis over
a period of time.
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Asset Depreciation
Physical
Economic depreciation depreciation
the gradual decrease in

utility in an asset with
use and time Functional
depreciation
Depreciation
Accounting depreciation Book
depreciation
The systematic allocation
of an asset’s value in
portions over its
depreciable life—often
used in engineering Tax
economic analysis depreciation

Basic Terminologies
 Market Value: The amount that will be paid by a willing buyer to
a willing seller for a property where each has equal advantage
and is under no compulsion to buy or sell. The MV approximates
the present value of what will be received through ownership of
the property , including the time value of money (or profit)
 Recovery Period: The number of years over which the basis of a

property is recovered through the accounting process. For the
classical methods of depreciation , this period is normally the
useful life .
 Recovery Rate: A percentage(expressed in decimal form) for each

year of the MACRS recovery period that is utilized to compute an
annual depreciation deduction.
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Basic Terminologies

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Basic Terminologies
 Adjusted Cost Basis: The original Cost basis of the asset adjusted
by allowable increase or decrease , is used to compute
depreciation and depletion deductions. E.g. the cost of any
improvement to a capital asset. Increase in cash flows will occur
in case of improvements and decrease will occur in case of
theft/loss/casualty.
 Basis or Cost Basis: also known as unadjusted cost balance The

initial cost of acquiring an asset (purchase price plus any sales
taxes), including transportation expenses and other normal costs
of making the asset serviceable for its intended use.

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Types of Depreciation
• Book Depreciation
– In reporting net income to
investors/stockholders
– In pricing decision
• Tax Depreciation
– In calculating income taxes
– In engineering economics, we use depreciation
in the context of tax depreciation

Book Depreciation Methods
Purpose: Used to report net income to
stockholders/investors
Types of Depreciation Methods:

 Straight-Line Method
 Declining Balance Method
 Sum of the Years’ Digits Method
 Unit Production Method

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Straight Line Depreciation

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Straight Line Depreciation

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Example 8-2
A new electric saw for cutting small pieces of lumber
in a furniture manufacturing plant has a cost basis of
$4,000 and a 10 year depreciable life. The estimated
SV of the saw is $0 at the end of 10-year period.
Determine the annual depreciation amounts using the

straight-line method. Tabulate the annual depreciation
amounts and the book value of the saw at the end of
each year

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Example 8-2

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Example 8-2
The depreciable amount for each year are shown below
EOY,k
0 - $4,000
1 $400 $3,600
2 $400 $3,200
3 $400 $2,800
4 $400 $2,400
5 $400 $2,000
6 $400 $1,600
7 $400 $1,200
8 $400 $800
9 $400 $400
10 $400 $0

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Example 8-3 – Straight-Line Method
Annual Depreciation
$10,000 Book Value
D1
Total depreciation at end of life

I = $10,000
$8,000
N = 5 Years
D2
S = $2,000
D = (I - S)/N
$6,000 D3
D4
B1 n Dn Bn
$4,000
B2 1 1,600 8,400
2 1,600 6,800
B3 D5 3 1,600 5,200
$2,000 4 1,600 3,600
B4 5 1,600 2,000
B5
0
0 1 2 3 4 5 n
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Declining Balance Method

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Declining Balance Method

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Example 8-5
 A car is bought for $ 4000 and it is expected to

depreciate by 20% each year. Calculate its book value
after 10 years
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Example 8-5
End of year Depreciation ($) Book value ($)
0 0 4000
1 800 3200
2 640 2560
3 512 2048
4 410 1638
5 328 1311
6 262 1049
7 210 839
8 168 671
9 134 537
10 107 430

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Double Declining Balance
Example 8.6:
A depreciable construction truck has a first cost of $20,000
with a $4,000 salvage value after 5 years. Find the (a)
depreciation, and (b) book value after 3 years using DDB
depreciation.
Solution:
(a) d = 2/n = 2/5 = 0.4
D3 = dB(1 – d)t-1
= 0.4(20,000)(1 – 0.40)3-1
= $2880

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Example 8.7 – Declining Balance Method
Annual Depreciation
$10,000 Book Value

I = $10,000
D1
N = 5 years
$8,000
S = $778
Dn =   Bn 1
$6,000 =   I (1 -   n 1
Bn  I (1   ) n
D2
B1
n Dn Bn
$4,000
0 $10,000
D3 1 $4,000 6,000
B2 D 2 2,400 3,600
$2,000 4 3
B3 1,440 2,160
D5
4 864 1,296
B4 B5
0 5 518 778
0 1 2 3 4 5 n

Example 8.8
DB Switching to SL
Asset: Invoice Price $9,000

Freight 500
Installation 500
Depreciation Base $10,000
Salvage Value 0
Depreciation 200% DB
Depreciable life 5 years
• SL Dep. Rate = 1/5

• a (DDB rate) = (200%) (SL rate)
= 0.40
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Units-of-Production Method

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Example 8-4

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Sum-of-Years’ Digits (SOYD) Method
SOYD is an accelerated depreciation method; more depreciation
occurs early in the asset's life than in its later life. Because of the
time value of money, an accelerated method is desirable for a
profitable business because it results in delaying the payment of
taxes.
•Principle
 Depreciation concept similar to DB but with decreasing
depreciation rate.
 Charges a larger fraction of the cost as an expense of the

early years than of the later years.

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 The digit corresponding to the number for each permissible year of life
are first listed in reverse order.
 The sum of these digits is then determined.
 The depreciation for any year is the number from reverse-ordered

listing for that year divided by the sum of the digits.
Year No. of year (RO) SYD Depreciation Factor

1 5 5/15
2 4 4/15
3 3 3/15
4 2 2/15
5 1 1/15
Sum of Digits 15
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A new electric saw for cutting small pieces of lumber
in a furniture manufacturing plant has a cost basis of
$4,000 and a 10 year depreciable life. The estimated
SV of the saw is $0 at the end of 10-year period.
Determine the annual depreciation amounts using the

straight-line method. Tabulate the annual depreciation
amounts and the book value of the saw at the end of
each year.

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End of year Depreciation ($) Book value ($)
0 0 4000
1 $727 3,272.73
2 654.55 2,618.18
3 581.82 2,036.36
4 509.09 1,527
5 436.36 1,090
6 363.64 727.27
7 290.91 436
8 218.18 218.18
9 145.45 72.73
10 72.73 0

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Example 10.7 – Sum-of-years’ digits method
Annual Depreciation
$10,000 Book Value

D1 I = $10,000
$8,000
N = 5 years
S = $2,000
SOYD = 15
$6,000
D2
B1 D3
$4,000
B2 n Dn Bn
D 1 (5/15)(8,000)=$2,667 $7,333
4 2 (4/15)(8,000)=$2,133 5,200
D5
$2,000 3 (3/15)(8,000)=$1,600 3,600
B3 4 (2/15)(8,000)=$1,067 2,533
5 (1/15)(8,000)=$533 2,000
0 B4 B5
0 1 2 3 4 5 n
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Depletion
Depreciation

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Depletion
The decrease in the value of the resources base that occurs
as a result of the consumption in the production of
products and resources in known as depletion.
 Depletion differs from depreciation in that depletion

results from a supply coming from the asset tends to
exhaust with the process extraction.
 Used to evaluate the values of mines, gas fields,

oilfields, timber forests etc.
 Same formulae i.e. SL and DB methods are used to

evaluate depletion and the resulting book value.
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Depletion
 In depreciation the property involved is usually replaced
with the similar property after it has been fully depreciated.
 In case of depletion of mineral and other resources such

replacement is usually not possible e.g. oil & gas , gold,
wood etc.
 Therefore in case of manufacturing , the amount charged for

depreciation expense is reinvested in new equipment for the
business to continue.
 However in depletion , as a result of resources becoming

scarce, the businesses might need to end their operations.

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Depletion
Types & Methods

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Cost Method

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Percentage Method
 The percentage method is applicable on metals, mines

geothermal deposits and coal mines, but not for timber.
 Examples:
 Sulfur & Uranium

 Gold, Silver, Copper, iron ore
 Coal , lignite & sodium chloride
 Clay, gravel, sand and stone

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Percentage Depletion vs. Cost
(Example 10.12) Depletion
Percentage Depletion
Gross income from sale of $16,425,000

45,000 ounces Cost depletion
= ($30,000,000/300,000)(45,000)
Depletion percentage 15%
= $4,500,000
Computed percentage $2,463,750
depletion
Gross income from sale of $16,425,000

45,000 ounces Allowable deduction
= $2,088,000
Less mining expenses 12,250,000
Taxable income from mine 4,175,000
50% Select cost depletion
Deduction limitation
with $4,500,000
Maximum depletion deduction $2,088,000
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Calculating the Allowable Depletion
Deduction
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Percentage Depletion Allowances for Mineral
Properties
Deposits Percentage
Oil and gas wells (only for certain domestic and gas production) 15
Sulfur and uranium, and, if from deposits in the United States, 22

asbestos, lead, zinc, nickel, mica, and certain other ores and
minerals
Gold, silver, copper, iron ore, and oil shale, if from deposits in the 15
United States
Coal, lignite, and sodium chloride 10
Clay and shale to be used in making sewer pipe or bricks 7.5
Clay (used for roofing tile), gravel, sand, and stone 5
Most other minerals; includes carbon dioxide produced from a well 14

and metallic ores.
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INCOME TAX
Basic Concept & After Tax

ROR
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Introduction to Tax
 Tax is a fee charged by a government on a product, income or
activity.
 There are two types of taxes . Direct taxes and Indirect taxes.
 If tax is levied directly on the income or wealth of a person,

then it is a direct tax e.g. income-tax, wealth tax.
 If tax is levied on the price of a good or service, then it is called

an indirect tax e.g. excise duty, custom duty, service tax and
sales tax or value added tax. In the case of indirect taxes, the
person paying the tax passes on the incidence to another
person.
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Income Taxes
 Taxes have an impact on cash flow and affect the
decisions management makes concerning
investments.
 Integrating tax considerations into economic
analysis requires a thorough understanding of two
issues.
 How the taxes are imposed.
 How they affect the economic analysis techniques.
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Tax Terminologies
 Gross Income
Total income for the tax year from all revenue-producing
functions of the enterprise.
 Income Tax
The total amount of money transferred from the enterprise to
the various taxing agencies for a given tax year
 Operating Expenses
All costs associated with doing business for the tax year
 Taxable Income
Calculated amount of money for a specified time period from
which the tax liability is determined
Tax Terminologies Continued
 Property Taxes
Assessed as a function of the value of property owned such as
land , buildings, equipment , and so on, and the applicable tax
rates. These taxes are levied by municipal, county and/ or state
governments.
 Sales Taxes
Assessed on the basis of purchases of goods and or/ services ,
and thus independent of gross income or profits.
 Excise Taxes
Federal taxes assessed as a function of the sale of certain goods
or services often considered non-necessities e.g. cigarettes &
alcohol and gasoline and are hence independent of the income or
profit of a business. “Sin Tax”
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Basic Concepts
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Example
 A famous clothing brand generates $1,500,000 of gross

income during its tax year and incurs operating expenses
of $800,000. Interest payments on borrowed capital
amount to $48,000. The total depreciation deductions
for the tax year equal $114,000 .What is the taxable
income (NIBT) of this firm?
Solution:
NIBT=?
$1,500,000-$800,000-$48,000-$114,000=$538,000

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Net Profit After Tax (NPAT)
 For Federal corporate income tax T is represented by a series of tax
rates
 The applicable tax rate depends upon the total amount of TI. Taxes
owed equals:
 Taxes = (taxable income) x (applicable rate) = t (Rk-Ek-dk)
 Amount of money remaining each year when income taxes are
subtracted from taxable income
 NIAT = (Rk-Ek-dk) – t (Rk-Ek-dk)= (1-t) (Rk-Ek-dk)
 Net profits (if positive) represent funds that are the claim of the
owners of the firm
 NIAT can be:
 “Saved” by the firm,
 Reinvested within the firm,
 Paid out as dividends to the stockholders,
 Some combination of paying dividends and reinvesting
Federal Corporate Tax Rates
 Corporate Tax Rates:
 No one single rate;
 Series of “graduated” rates;
 TI is partitioned into up to 8 brackets of taxable income
 A tax rate is then applied to each bracket of taxable income
and then summed across all applicable brackets.
 See Tables in your respective books for the 8 bracket rates
 Assume TI = $200,000.
 1st $50,000 (0.15) = $7,500 ($150,000 left)
 Next $25,000 (0.25) = $6,250 ($125,000 left)
 Next $25,000 (0.34) = $8,500 ($100,000 left)
Tax all monies between $100,000 to $335,000 at 39%
 Last $100,000 (0.39) = $39,000
Marginal Tax Rates
 Each bracket rate is termed a “marginal” rate
 The first $50,000 of TI is taxed at the bracket rate of 15%
 Any additional TI over $50,000 flows into the next bracket
 The next $25,000 or part thereof, is taxed at the marginal
bracket rate of 25%
 Each additional $ that moves a firm into a higher bracket is
taxed at the higher bracket’s tax rate
 Total Tax: Add the bracket tax amounts
 $7,500+6,250+8,500+39,000=$61,250
 Tax as a % of TI: 56,250/$200,000 = 30.625%
Marginal Tax Rates

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Example
 A firm has a gross income of $5,270,000, expenses

(excluding capital) 0f $2,927,500, and depreciation
deduction of $1,874,300. What would be its taxable
income and federal income tax for the tax year based on
the equation of taxable income and tax rate given in the
table .

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Solution
 Taxable income = $468,200

 Income tax = 15%+25%+34%+39%+34%
 TOTAL = $159,188

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State and Federal
 Most states have a state and local corporate tax
structure
 Firms must pay:
 Federal corporate taxes, and possibly
 State corporate taxes, and even
 County or city income taxes.
 If this is the case, apply a combined tax rate
 t = state rate + (1 – state rate) (Federal Rate)
 State income taxes are deductible expenses for federal
income tax purposes
Example
 Calculate the combined federal and state income taxes

for a business that is subject to a California state income
tax of 8.84%. Federal income tax rates as per the table.
The company's taxable income for the year of interest is
$11.0 million.
A $972,400
B $3,750,000
C $4,722,400
D $4,822,400

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Personal vs. Corporate
 Individuals must apply the various standard or itemized
deductions permitted by current law.
 Corporations deduct actual cash-flow expenses
 Individuals have to file as either:
 Single,
 Married,
 Head of household
 Individual Tax Rates: Similar bracket design with 5
brackets; 15%, 28%, 31%, 36%, 39.6%
BTCF and ATCF
 BTCF:
 Actual real cash flows associated with an investment BEFORE
any income tax considerations
 Next, BTCF will be defined as: gross income –expenses
 BTCF=Rk-Ek
 ATCF for a given time period is defined as:
 ATCFk = BTCFk –Tk=(Rk-Ek)- t(Rk-Ek-dk)=(1-t)(Rk-Ek)+ tdk
 ATCFk = NIATk + tdk
 Focus on (Rk-Ek-dk)
 For some time periods this term could be negative
 Operating “loss,” which can generate a “negative” tax
 Let the sign take care of itself!
Taxes in the Perspective of Pakistan
 Federal Board of Revenue(FBR) is responsible for

administering taxation in Pakistan.
 FBR is administered by the Govt. of Pakistan.
 The current taxation system in Pakistan is defined by the

Income Tax Ordinance 2001, promulgated on 13
September 2001.

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Income Tax Slabs Pakistan 2018-2019
 As per income tax exemption bill passed by Government of Pakistan, following slabs
and income tax rates will be applicable for salaried persons for the year 2018-2019:
 Where the taxable salary income does not exceed Rs. 400,000 the rate of income
tax is 0%.
 Where the taxable salary income exceeds Rs. 400,000 but does not exceed Rs.
800,000 the rate of income tax is Rs. 1000.
 Where the taxable salary income exceeds Rs. 800,000 but does not exceed Rs.
1,200,000 the rate of income tax is Rs. 2000.
 Where the taxable salary income exceeds Rs. 1,200,000 but does not exceed Rs.
2,500,000 the rate of income tax is 5% of the amount exceeding Rs.
1,200,000 or Rs. 2000. which one is greater.
4,000,000 the rate of income tax is Rs. 65,000 + 15% of the amount exceeding Rs.
2,500,000.
8,000,000 the rate of income tax is Rs. 290,000 + 20% of the amount exceeding Rs.
4,000,000.
 Where the taxable salary income exceeds Rs. 8,000,000 the rate of income tax
is Rs. 1,090,000 + 25% of the amount exceeding Rs. 8,000,000
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Capital Gain and Capital Loss
 Firms sell or dispose of assets from time to time
 Assets that are disposed do have a book value (Could be + or“0”)
 Depreciation Recapture: It occurs when an asset is sold for
more than its book value but less than the cost basis.
 DR = Selling Price – Current Book Value;
 There is a tax on Depreciation Recapture and is treated differently
from normal income.
 Capital Gain : When an asset is sold for more than its cost
basis.
 CG = Selling Price – First Cost
 Certain Assets will gain value over time and could be sold for more
than what was originally paid for them.
 This will generate a tax liability and tax will have to be paid!
Capital Gain and Capital Loss
 Capital Loss: A capital loss occurs when an asset is
sold for less than its current book value.
 Could generate a tax savings since the “loss” could be tax
deductible within certain rules.

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Four Possibilities
 The asset is sold for a price > BVt
 SP > BVt generates a tax liability
 The asset is sold for a price = BVt

 SP = BVt no tax liability generated
 The asset is sold for a price < BVt

 SP < BVt generates a tax savings
 The asset is sold for a price > Original basis (B)

Example
A corporation with a federal income tax rate of 34% placed a depreciable asset in service
at a cost basis of $10,000. After two years of use, it was sold for $14,000 because the
asset was in short supply. When sold, the asset had a book value of $6,400.
Which statement below correctly gives the federal income tax due as a result of asset
disposal?
Choose an answer by clicking on one of the letters below, or click on "Review topic" if
needed.
A The capital gain of $7,600 is taxed at 20%, resulting in a tax due of $1,520.
B Both the capital gain of $4,000 and the depreciation recapture of $3,600 are taxed at
34%, resulting in a tax due of $2,584.
C The capital loss of $4,000 can be used to offset capital gains the company realizes
through disposal of other assets.
D The ordinary income of $14,000 is taxed at 34%, resulting in a tax due of $4,760.

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Engineering Economy

 Understand basic terms of asset depreciation

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 Engineering projects often involve

 But what is Depreciation?

Depreciation is the decrease in value of physical properties

 It is to be specific an accounting concept that establishes

 Why do we compute depreciation?

End of Market Loss of

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Gross Income -Expenses:

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Assets depreciate for a variety of reasons:

 Use related physical loss, e.g. tire wear on a car. This

 Time related physical loss: e.g., rusting of cars. This type

 Functional loss : e.g., style changes, changes in safety

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• Assets used in business or held for production of

• Assets having a definite useful life and a life longer than

• Assets that must wear out, become obsolete or lose

A qualifying asset for depreciation must satisfy all of the

Land (land can never be depreciated)

Inventory – You cannot depreciate property held for

Leased property – The value of the lease is already

Raised Market Livestock (Because there is no cost to

 Purchase Price – Market Value

the gradual decrease in

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 Recovery Period: The number of years over which the basis of a

 Recovery Rate: A percentage(expressed in decimal form) for each

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 Basis or Cost Basis: also known as unadjusted cost balance The

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Types of Depreciation Methods:

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Determine the annual depreciation amounts using the

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Total depreciation at end of life

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 A car is bought for $ 4000 and it is expected to

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$10,000 Book Value

Total depreciation at end of life

29 Muniba Sana Younis

Asset: Invoice Price $9,000

• SL Dep. Rate = 1/5

Muniba Sana Younis

Muniba Sana Younis 12/27/2018

Muniba Sana Younis 12/27/2018

 Charges a larger fraction of the cost as an expense of the

Muniba Sana Younis 12/27/2018

 The sum of these digits is then determined.

 The depreciation for any year is the number from reverse-ordered

Year No. of year (RO) SYD Depreciation Factor

Muniba Sana Younis 12/27/2018