Depreciation

Reduction in value of an asset

Wear & Tear
Deterioration
Obsolescence

Systematic recovery of invested capital into an asset

Tax or capital recovery

Capital invested
P=Capital Invested

o1st cost
oInitial investment
oCapital

expenditure

Depreciation life
n=depreciation life

Estimated life (mfl)

Useful life
Depreciation period

Salvage Value
L=Salvage value

End of depreciation life value

Final value
Terminal value
Final worth
What you can sell the asset for

Depreciation Amount
Dj = Depreciation amount (charge) for year j

Estimate of capital recovery during the year

Book Value
Bj=
Bj Book Value

Unrecovered capital
Un-depreciated balance

at the end of year

Straight- Line Deprecation

Constant yearly deprecation amount book value

decreases at a constant rate

PL
D =
j
n
Capital cost - Salvage Value
# of depreciation yrs(usefullife)

Book Value
Book Value
d
B = P ( P L)
j
n
year j
Capital cost - (
)(Capital Cost - Salvage Value)
depreciation life

Example:
Lets say you buy a new brand F 350 for $40,000. Its salvage value

is $5,000 and you will depreciate the asset for 5 years:

Dj =

40 ,000 5,000 35,000

=
= 7,000 / year
5
5

D j = B j 1 B j

& B j = P Dx
x =1

Total accumulated depreciation through the end of year j

1
B j = 40 ,000 ( )( 40,000 7,000 )
3
= 40 ,000 (0.2)(33,000 )
= 40 ,000 6,600 = $33,400

Then, youd do it for year 2 with 40,000-(2/5)(40,000-5,000)=26,000

Some-of-the-Years-Digits Depreciation (SYD)

Accelerated depreciation schedule
Yearly depreciation amounts decrease with time

Dj =

(n j + 1)( P L)
n(n + 1)
2

& B j = ( P L)(

n j n j +1
)(
)+ L
n
n +1

SYD Example:
Lets use the truck example again where incentives are made to

small business owners to purchase new capital equipment to

stimulate the economy.
(5 1 +1)
D1 =
( 40 ,000 5,000 )
5(5 +1)
A schedule (table) will be developed
2

5
(40 ,000 5,000 )
5(6)
2
5
= (40 ,000 5,000 ) = 0.3333 (35 ,000 )
15
= $11,665.50
=

(5 2 +1)
( 40 ,000 5,000 )
5(5 +1)
2
4
= (40 ,000 5,000 ) = 0.2666 (35 ,000 )
15
= $9,333.34

D2 =

SYD Example (cont.)

5 1 5 1 + 1
B1 = (40,000 5,000 )(
)(
) + 5,000
5
5 +1
4 5
= (35,000 )( )( ) + 5,000
5 6
= (35,000 )(0.8)(0.8333 ) + 5,000
= $28,332.40
5 2 5 2 +1
B2 = (40,000 5,000 )(
)(
) + 5,000
5
5 +1
3 4
= (35,000 )( )( ) + 5,000
5 6
= (35,000 )(0.6)(0.6666 ) + 5,000
= $18,999.96
Then, make a depreciation schedule (table)

SYD Example (cont.)

End of Year

Depreciation amount

Book Value
$40,000

$11,665.50

$28,332.40

$9,333.33

$18,999.96

3
4
5

There will be some rounding error by subtracting depreciation-

amount to the book value to get preceding years book value

SYD Example (cont.)

(5 3 +1)
D =
( 40 ,000 5,000 )
3
5(5 +1)
2
3
=
(35 ,000 ) =$7,000
15
D

(5 4 +1)
( 40 ,000 5,000 )
4
5(5 +1)
2
2
=
(35 ,000 ) =$4,666 .67
15
=

(5 5 +1)
D =
( 40 ,000 5,000 )
5
5(5 +1)
2
1
=
(35 ,000 ) =$2,333 .34
15

B3 = ( 40,000 5,000 )(

5 3 5 3 +1
)(
) + 5,000
5
5 +1

2 3
= (35,000 )( )( ) + 5,000
5 6
= $12,000
1 2
B4 = (35,000 )( )( ) + 5,000
5 6
= $7,333.34
0 1
B5 = (35,000 )( )( ) + 5,000
5 6
= $5,000

SYD Example (cont.)

End of Year

Depreciation amount

Book Value
$40,000.00

$11,665.50

$28,332.40

$9,333.33

$18,999.96

$7,000.00

$12,000.00

$4,666.67

$7,333.34

$2,333.34

$5,000.00

Declining Balance Depreciation

Fixed % depreciation

Yearly depreciation determined multiply by

Book value at beginning of year by a constant fraction.

Depreciation Amount:

D j = aB j 1

a = Constant Franction

B j = (1 a ) j P Book Value

Yearly depreciation amounts:

D j = aP(1 a ) j 1

How do you get a (the constant fraction)

2 ways

ensure that book value and salvage value are equal at end of depreciation life
1)
#1:
L
1)
L = (1 a) n a = 1 - n

However:

Cannot be used to depreciate an asset to a salvage value of zero

If the salvage value is very small with respect to initial cost of asset,

initial depreciation values may be unreasonably large

#2: A reasonable rate taken from tax regulations as long as the

Max yearly depreciation < 200% of the straight line rate

(2/n)P (max tax depreciation in any year)

Since the straight line rate is 1/n, LDROT set value of a=2/n

Double declining balanced (DDB) method

Some tax regulations do not allow DDB

Some requirements are 150% or 125%

so a = 1.50/n or 1.25/n

#2 does not guarantee that the salvage value will be obtained at the
depreciation life

Switch to straight line depreciation

Switch when straight line depreciation (based on amount and life) >
than DDB

B j 1 L
n ( j 1)

> aB j 1

Example
So let's keep using the truck example, but use 5 years

Using:

a = 1- n

L
5000
= 1 5
= 1 5 0.125= 1 0.6597= 0.3402
P
40,000

D1 = aB11 = 0.3402 40,000 = $13,609.84

B1 = (1 a) j P = (1 0.3402) 40,000= $26,392.00

End of Year

Depreciation amount

Book Value
$40,000

$13,609.84

$26,392.00

$8,978.56

$17,413.44

$5,924.05

$11,489.39

$3,908.69

$7,580.70

$2,578.95

$5,001.75

Example (cont.)
How do you get year 2
Remember:

D j = aP (1 a ) j 1
D2 = ( 0.3402 )( 40 ,000 )( 1 0.3402 )21 = $8,978 .56
B j = (1 a ) j P =
B2 = (1 0.3402 ) 2 (40,000 ) = $17 ,413 .44
D3 = ( 0.3402 )( 40 ,000 )( 1 0.3402 )31 = $5,924 .05
B3 = (1 0.3402 ) 3 (40,000 ) = $11,489 .39
D4 = ( 0.3402 )( 40 ,000 )( 1 0.3402 )41 = $3,908 .69
B4 = (1 0.3402 ) 4 (40,000 ) = $7,580 .70
D4 = ( 0.3402 )( 40 ,000 )( 1 0.3402 )51 = $2,578 .95
B5 = (1 0.3402 )5 (40,000 ) = $5,001 .75

Result:
DDB
Therefore, truck will maintain a

book value equal to its salvage

value for the remainder of its
life.

2 2
= = 0.4
n 5
So, repeat as beforeexcept a = 0.4000
a=

D1 = (0.4)(40,000) = $16,000.00
B1 = (1 0.4)(40,0000) = $24,000.00
D2 = (0.4)(1 0.4)(40,000) = $9,600.00
B2 = (1 0.4) 2 (40,0000) = $14,400.00
D3 = (0.4)(1 0.4) 2 (40,000) = $5,760.00
B3 = (1 0.4)3 (40,0000) = $8,640.00
D4 = (0.4)(1 0.4)3 (40,000) = $3,456.00
B4 = (1 0.4) 4 (40,0000) = $5,184.00
D5 = (0.4)(1 0.4) 4 (40,000) = $2,073.60
B5 = (1 0.4)5 (40,0000) = $3,110.40

Results table:
End of Year

Depreciation amount

Book Value

$40,000

$16,000.00

$24,000.00

$9,600.00

$14,400.00

$5,760.00

$8,640.00

$3,456.00

$5,184.00

$2,073.60

$3,110.40

Less than salvage value($5,000)!

Switch to straight line method

So, depreciation in year 5 is limited to amount necessary to obtain the

salvage value which is $5184.00 - $5000.00 = $184.00

Asset fully depreciated at the end of 4 years

Now, if you used to say the 125% rate or 150%rate

with a switch to straight line
Depreciation 1st test it

1.25
= 0.25
5
B5 = (1 0.25) 5 (40,000) = $9,492.19
a=

since B5 > the salvage value ($5000)

Then, we can switch to straight line method.

End of
Year

0
1
2
3
4
5
6

Declining
Balance

Straight
Line

Final
Depreciation

Book Value

D1 = (0.25)(40,000) = $10,000
B1 = (1 0.25)(40,000) = $30,000
D2 = (0.25)(1 0.25)(40,000) = $7,500
B2 = (1 0.25) 2 (40,000) = $22,500
D3 = (0.25)(1 0.25) 2 (40,000) = $5,625
B3 = (1 0.25) 3 (40,000) = $16,875
D4 = (0.25)(1 0.25)3 (40,000) = $4,218.75
B4 = (1 0.25) 4 (40,000) = $12,656.25
D5 = (0.25)(1 0.25) 4 (40,000) = $3,164.06
B5 = (1 0.25) 5 (40,000) = $9,492.19
D6 = (0.25)(1 0.25)5 (40,000) = $2,373.05
B6 = (1 0.25) 6 (40,000) = $7,119.14
D7 = (0.25)(1 0.25) 6 (40,000) = $1,779.79
B7 = (1 0.25) 7 (40,000) = $5,339.36

Straight Line:
40,000 5,000
= $7,000
5
1
B1 = 40,000 ( 40,000 5,000) = $33,000
5
2
B2 = 40,000 (40,000 5,000) = $26,000
5
3
B3 = 40,000 (40,000 5,000) = $19,000
5
4
B4 = 40,000 (40,000 5,000) = $12,000
5
Then, just use the straight line method until
D1 =

you reach to the salvage value

Sinking-Fund Depreciation
Based on a series of equal annual deposits over the

depreciation life of an asset that are equal to the

depreciable amount (initial cost salvage value)
A = (P-L)(A/F. i, n) where:
n
i

= depreciation life
= some specific interest rate

Dj = (P-L)(A/F, i, n)(F/P, i, (j-1))

Bj = P-(P-L)(A/F, i, n)(F/A, i, j)

Sinking Fund Depreciation

This model assumes that an asset depreciates at an

increasing rate
Rarely used for tax computation
Sometimes used by government agencies
So, say the government buys a new F350 truck,
interest rate is 10% and the depreciable life is 7
years

Sinking Fund Depreciation

D1 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (1-1))
D2 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (2-1))
D3 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (3-1))
D4 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (4-1))
D5 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (5-1))
D6 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (6-1))
D7 = ($40,000-$5,000)(A/F, 10, 7)(F/P, 10, (7-1))

Sinking Fund Depreciation

D1 = ($35,000)(0.1054)(1.0000) = $3,689
D2 = ($35,000)(0.1054)(1.1000) = $4,057.9
D3 = ($ 35,000)(0.1054)(1.210) = $4,463.69
D4 = ($ 35,000)(0.1054)(1.331) = $4,910.06
D5 = ($ 35,000)(0.1054)(1.464) = $5,400.70
D6 = ($ 35,000)(0.1054)(1.611) = $5,942.98
D7 = ($ 35,000)(0.1054)(1.772) = $6,336.91

Sinking Fund Depreciation

B1 = $40,000-[($35,000)(0.1054)(1.000)] = $36,311
B2 = $40,000-[($35,000)(0.1054)(2.100)] = $32,253.10
B3 = $40,000-[($35,000)(0.1054)(3.310)] = $27,789.41
B4 = $40,000-[($35,000)(0.1054)(4.641)] = $22,879.351
B5 = $40,000-[($35,000)(0.1054)(6.105)] = $17,478.655
B6 = $40,000-[($35,000)(0.1054)(7.716)] = $11,535.676
B7 = $40,000-[($35,000)(0.1054)(9.487)] = $5,002.457

Sinking Fund Depreciation

End of Year

Depreciation Book Value

$40,000.00

$3,689.00

$36,311.00

$4,057.90

$32,253.10

$4,463.69

$27,789.41

$4,910.06

$22,879.35

$5,400.70

$17,478.66

$5,942.98

$11,535.68

$6,336.91

$5,002.46

Usage Depreciation
Previous depreciation based on time only
This depreciation is based on actual asset use

PL
D =
Uj

Where U = total usage expected during the lifetime

( )

of the asset
The units of U and Uj depend on the type of asset

Usage Depreciation
So, a new F350 is purchased for use in a

construction company.
How much will the asset be used?
If the asset (truck) will be used for 8 hrs / day, then
the usage is 100%
Lets say the useful life is 100,000 miles and the
sage per year will be 15,000 miles.
The original cost is $40,000 and the Salvage value
is $5,000
=>

$40,000 $5,000
$35,000
Dj =
(15,000) =
(15,000) = 0.35(15,000) = $5,250 / yr
100,000

100,000

Capital Recovery and Return

Used in economic analyses
Recovery of invested capital and a return on yearly

unrecovered capital
It is like loaning $
The Principal in the invested capital
The return is the recovery of the interest
If it is assumed that the yearly depreciation = the
yearly amounts of capital recovered then,

Capital Recovery and Return

Capital Recovery (and return) is calculated as:

j
j
j 1
Where i = rate of return on unrecovered capital
Equivalent Annual Amounts of Capital Recovery and

CR = D + (i ) B

Return (ECR) is calculated as follows. StraightLine or Sum-of-the-Years Digits as used for ECR
ECR = CR1 ( P / F , i,1) + CR 2( P / F , i,2) CRj ( P / F , i, j )( A / P, i, n)

Capital Recovery and Return

Straight Line
Ford F350, P = $40,000, L = $5,000, 10% return

PL
j
Dj =
, B j = P ( P L)
n
n
End of Year

Depreciation

Book Value

Return

Capital
Recovery

$40,000.00

$7,000.00

$33,000.00

$4,000.00

$11,000.00

$7,000.00

$26,000.00

$3,300.00

$10,300.00

$7,000.00

$19,000.00

$2,600.00

$9,600.00

$7,000.00

$12,000.00

$1,900.00

$8,900.00

$7,000.00

$5,000.00

$1,200.00

$8,200.00

Capital Recovery and Return SYOD

Ford F350, P = $40,000, L = $5,000, 10% return

(n j + 1)( P L
n j n j + 1

Dj =
,
B
=
(
P

L
)
+ L

j
n(n + 1)
n n + 1

Depreciation
Book Value Return Capital
2
End of Year
Recovery
0
$40,000.00
1

$11,665.50

$28,332.40

$4,000.00 $15,665.50

$9,333.33

$18,999.96

$2,833.24 $12,166.57

$7,000.00

$12,000.00

$1,899.99 $8,899.99

$4,666.67

$7,333.33

$1,200.00 $5,866.67

$2,333.33

$5,000.00

$733.33

$3,066.66