Depreciation

As we note elsewhere, accounting depreciation is a noncash deduction. As a result, depreciation has cash flow consequences only because it influences the tax bill. The way that depreciation is computed for tax purposes is thus the relevant method for capital investment decisions. Not surprisingly, the procedures are governed by tax law. We now discuss some specifics of the depreciation system enacted by the Tax Reform Act of 1986. This system is a modification of the accelerated cost recovery system (ACRS) instituted in 1981.

Modified ACRS Depreciation (MACRS) Calculating depreciation is normally very mechanical. Although there are a number of ifs, ands, and buts involved, the basic idea under MACRS is that every asset is assigned to a particular class. An asset's class establishes its life for tax purposes. Once an asset's tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage.10 The expected salvage value (what we think the asset will be worth when we dispose of it) and the expected economic life (how long we expect the asset to be in service) are not explicitly considered in the calculation of depreciation.

Some typical depreciation classes are given in Table 10.6, and associated percentages (rounded to two decimal places) are shown in Table 10.7.11

10Under certain circumstances, the cost of the asset may be adjusted before computing depreciation. The result is called the depreciable basis, and depreciation is calculated using this number instead of the actual cost.

11For the curious, these depreciation percentages are derived from a double-declining balance scheme with a switch to straight-line when the latter becomes advantageous. Further, there is a half-year convention, meaning that all assets are assumed to be placed in service midway through the tax year. This convention is maintained unless more than 40 percent of an asset's cost is incurred in the final quarter. In this case, a midquarter convention is used.

Ross et al.: Fundamentals I IV. Capital Budgeting I 10. Making Capital I I © The McGraw-Hill of Corporate Finance, Sixth Investment Decisions Companies, 2002

Edition, Alternate Edition

CHAPTER 10 Making Capital Investment Decisions 323

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Depreciation

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