035

Given the availability of the above information, the procedure to determine the ATCF on a year-by-year basis proceeds using the following calculation for each year:

• Taxable Income = BTCF - Loan Interest - Bond Interest - Deprecation

• ATCF = BTCF - Total Loan Payments - Total Bond Payments - Taxes

An important observation is that Depreciation reduces Taxable Income (hence, taxes) but does not directly enter into the calculation of ATCF since it is not a true cash flow. It is not a true cash flow because no cash changes hands. Depreciation is an accounting concept design to stimulate business by reducing taxes over the life of an asset. The next section provides additional information about depreciation.

4.5.2 Depreciation

Most assets used in the course of a business decrease in value over time. U.S. Federal income tax law permits reasonable deductions from taxable income to allow for this. These deductions are called depreciation allowances. To be depreciable, an asset must meet three primary conditions: (1) it must be held by the business for the purpose of producing income, (2) it must wear out or be consumed in the course of its use, and (3) it must have a life longer than a year.

Many methods of depreciation have been allowed under U.S. tax law over the years. Among these methods are straight line, sum-of-the-years digits, declining balance, and the accelerated cost recovery system. Descrip tions of these methods can be found in many references including economic analysis text books [White, et al., 1998]. The method currently used for depreciation of assets placed in service after 1986 is the Modified Accelerated Cost Recovery System (MACRS). Determination of the allowable MACRS depreciation deduction for an asset is a function of (1) the asset's property class, (2) the asset's basis, and (3) the year within the asset's recovery period for which the deduction is calculated.

Eight property classes are defined for assets which are depreciable under MACRS. The property classes and several examples of property that fall into each class are shown in Table 4.2. Professional tax guidance is recommended to determine the MACRS property class for a specific asset.

The basis of an asset is the cost of placing the asset in service. In most cases, the basis includes the purchase cost of the asset plus the costs necessary to place the asset in service (e.g., installation charges).

Given an asset's property class and its depreciable basis the depreciation allowance for each year of the asset's life can be determined from tabled values of MACRS percentages. The MACRS percentages specify the percentage of an asset's basis that are allowable as deductions during each year of an asset's recovery period. The MACRS percentages by recovery year (age of the asset) and property class are shown in Table 4.3.

Example 2

Determine depreciation allowances during each recovery year for a MACRS 5-year property with a basis of $10,000.

Table 4.2 MACRS property classes

Property Class

Example Assets

3-Year Property

special handling devices for food special tools for motor vehicle manufacturing

5-Year Property

computers and office machines general purpose trucks

7-Year Property

office furniture most manufacturing machine tools

10-Year Property

tugs & water transport equipment petroleum refining assets

15-Year Property

fencing and landscaping cement manufacturing assets

20-Year Property

farm buildings utility transmission lines and poles

27.5-Year Residential Rental Property

rental houses and apartments

31.5-Year Nonresidential Real Property

business buildings

Year 3 deduction: $10,000 * 19.20% = $1,920 Year 4 deduction: $10,000 * 11.52% = $1,152 Year 5 deduction: $10,000 * 11.52% = $1,152 Year 6 deduction: $10,000 * 5.76% = $576

The sum of the deductions calculated in Example 2 is $10,000 which means that the asset is "fully depreciated" after six years. Though not shown here, tables similar to Table 4.3 are available for the 27.5-Year and 31.5-Year property classes. Their usage is similar to that outlined above except that depreciation is calculated monthly rather than annually.

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