Notice that the MACRS percentages sum up to 100 percent. As a result, we write off 100 percent of the cost of the asset, or $12,000 in this case.

Book Value versus Market Value In calculating depreciation under current tax law, the economic life and future market value of the asset are not an issue. As a result, the book value of an asset can differ substantially from its actual market value. For example, with our $12,000 car, book value after the first year is $12,000 less the first year's depreciation of $2,400, or $9,600. The remaining book values are summarized in Table 10.8. After six years, the book value of the car is zero.

Suppose that we wanted to sell the car after five years. Based on historical averages, it would be worth, say, 25 percent of the purchase price, or .25 X $12,000 = $3,000. If we actually sold it for this, then we would have to pay taxes at the ordinary income tax rate on the difference between the sale price of $3,000 and the book value of $691.20.

12There are, however, depletion allowances for firms in extraction-type lines of business (e.g., mining). These are somewhat similar to depreciation allowances.

13It may appear odd that five-year property is depreciated over six years. As described elsewhere, the tax accounting reason is that it is assumed we have the asset for only six months in the first year and, consequently, six months in the last year. As a result, there are five 12-month periods, but we have some depreciation in each of six different tax years.

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

324 PART FOUR Capital Budgeting

For a corporation in the 34 percent bracket, the tax liability would be .34 X $2,308.80 = $784.99.14

The reason that taxes must be paid in this case is that the difference between market value and book value is "excess" depreciation, and it must be "recaptured" when the asset is sold. What this means is that, as it turns out, we overdepreciated the asset by $3,000 - 691.20 = $2,308.80. Because we deducted $2,308.80 too much in depreciation, we paid $784.99 too little in taxes, and we simply have to make up the difference.

Notice that this is not a tax on a capital gain. As a general (albeit rough) rule, a capital gain occurs only if the market price exceeds the original cost. However, what is and what is not a capital gain is ultimately up to taxing authorities, and the specific rules can be very complex. We will ignore capital gain taxes for the most part.

Finally, if the book value exceeds the market value, then the difference is treated as a loss for tax purposes. For example, if we sell the car after two years for $4,000, then the book value exceeds the market value by $1,760. In this case, a tax saving of .34 X $1,760 = $598.40 occurs.

MACRS Depreciation

The Staple Supply Co. has just purchased a new computerized information system with an installed cost of $160,000. The computer is treated as five-year property. What are the yearly depreciation allowances? Based on historical experience, we think that the system will be worth only $10,000 when Staple gets rid of it in four years. What are the tax consequences of the sale? What is the total aftertax cash flow from the sale?

The yearly depreciation allowances are calculated by just multiplying $160,000 by the five-year percentages found in Table 10.7:


MACRS Percentage


Ending Book Value

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