Applied Economics for Engineers Prepared by Dr.

Kashif Noor

Course Title : Applied Economics for Engineers

Course Code : MF-303
Course Teacher: Dr. Kashif Noor
Handout : 17th

Depreciation
Depreciation is the decrease in value of physical properties or Asset with the passage of
time and use.
Dn = ∑𝒏𝒊=𝟎 𝒅𝒊
Asset : Goods own from the business point of view is known as Asset. Asset may be tangible
asset and Intangible asset
1. Tangible property can be seen or touched, and it includes two main types called
personal property and real property. Personal property includes assets such as
machinery, vehicles, equipment, furniture, and similar items. In contrast, real property is
land and generally anything that is erected on, growing on, or attached to land. Land
itself, however, is not depreciable, because it does not have a determinable life.
2. Intangible property is personal property such as acopyright, patent, or franchise.

Book Value (B.V.) :

• The worth of a depreciable property as shown on the accounting records of a company.
• It represents the amount of capital that remains invested in the property and must be
recovered in the futurethrough the accounting process.
(B.V.)n = P - Dn
When ;
(i) S.V. > B.V. ; Profit
(ii) S.V. < B.V. ; loss or –ve profit
(iii) S.V. = B.V. ; Recovery of investment neither profit nor loss

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Depreciation in terms of Book Value (B.V.) :

Dn = P - (B.V.)n
Also ,

Dn = ∑𝒏𝒊=𝟏 𝒅𝒊

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.

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.

Salvage value (S.V.)

The estimated value of a property at the end of its useful life. It is the expected selling price
of a property when the asset can no longer be used productively by its owner.

Useful life
• The expected (estimated) period that a property will be used in a trade or business to
produce income.
• It is not how long the property will last but how long the owner expects to productively
use it.
Cost Basis (P):
• The initial cost of acquiring an assets (purchasing price +sales tax) including
transportation expenses and other normal cost of making the assets serviceable for its
intended use.

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Types of Depreciation
There are following major types of depreciation:
1) Normal Depreciation
a) Physical depreciation
b) Functional depreciation
2) Monetary Depreciation

1) Normal Depreciation
a) Physical Depreciation:
b) Physical depreciation is due to decrease in the physical ability if the property or
asset to produce desire results and the main cause of physical depreciation is
wear and tear.
c) It is the function of two main things ; use and time

Use Roughly - - - - - - - - - - - - Depreciation increases

Time passes- - - - - - - - - - - - Depreciation increases
Good maintenance- - - - - - - - - - - Depreciation decreases

b) Functional Depreciation:
• Functional depreciation is due to decrease in demand for the function of asset
(that the property was designed to serve).
• The main cause of functional depreciation are change in technology and change
in taste
2) Monetary Depreciation
• During the inflation, when the price of the property increases, then recovery of
capital is too difficult, and the recovered capital will not be sufficient to provide
an identical replacement due to increase in price limit and decrease in worth of
capital.

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

• Such type of lacking to purchase identical replacement is known as Monetary

depreciation.

Methods of Depreciation
There are following methods of depreciation :
1) Straight-Line (SL) Method
2) Sum of Year Digit (SYD)
3) Declining Balance (DB)
4) Double Declining Balance (DDB) Depreciation
5) MACRS

Straight Line Method (S.L.)

• SL depreciation is the simplest depreciation method.
• It assumes that a constant amount is depreciated each year over the depreciable
(useful) life of the asset.
• The SL (cumulative) depreciation is determined by:
(𝑷−𝑺)
𝐷n = 𝑿𝒏
𝑵

• Where,
• 𝐷n = 𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑖𝑛 "n" 𝑦𝑒𝑎𝑟𝑠
• 𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
• 𝑁 = 𝑇𝑜𝑡𝑎𝑙 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑜𝑟 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒𝑙𝑖𝑓𝑒
• 𝑆 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
• 𝑃 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 or Cost basis

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

If n= 1 year
Then;
(𝑷−𝑺)
d= 𝑵

Where d is annual Depreciation

Numerical
Q A new electric motor cost $ 4,000 and has a ten year depreciable life. The estimated savage
value of the motor is zero at the end of 10 years. Calculate the annual depreciable amounts and
the book value of the motor at the end of each year by straight line (SL) method.

Numerical

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Sum of the Year Digit (SYD) Method

• This method provide larger depreciation during the early years of ownerships, then in
the later years.
• The book value curve follows convex of original shape.
• Depreciation charges are very high in the first few years but decreases rapidly in later
years of the asset life.
• By showing larger depreciation we can save TAX .
• This technique depends on life . If life is less , the SYD method is not suitable

Total 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 in n years:

Dn = ∑𝒏𝒊=𝟎 𝒅𝒊 = (𝑃 − 𝑆) × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 Reverse
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 :
(B.V.)n =P- ∑𝒏𝒊=𝟎 𝒅𝒊 = 𝑃 − (𝑃 − 𝑆) × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑒𝑣𝑒𝑟𝑠𝑒
• Depreciation factor for any year is the reverse digit for that year divided by the sum of
the digit years.
𝑹𝒆𝒗𝒆𝒓𝒔𝒆 𝑫𝒊𝒈𝒊𝒕
Depreciation factor = 𝑺𝒖𝒎 𝒐𝒇 𝒅𝒊𝒈𝒊𝒕 𝒚𝒆𝒂𝒓𝒔

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

𝟒
Depreciation factor (for year 2 ) = 𝟏𝟓

Depreciation Reverse : is the sum of the reverse digits upto the required year divided by
the sum of digits.
𝑆𝑢𝑚 𝑜𝑓 𝑅𝑒𝑣𝑒𝑟𝑠𝑒 𝐷𝑖𝑔𝑖𝑡
Depreciation Reverse = 𝑆𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡 𝑦𝑒𝑎𝑟𝑠

Example:

NOTE:
Total 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 in n years:
(i) Dn = ∑𝑛𝑖=0 𝑑𝑖
(ii) Dn = (𝑃 − 𝑆) × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 Reverse
(iii) Dn = P – (B.V.)n
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 in any particular year:
dn = (𝑃 − 𝑆) × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 factor
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 :
(i) (B.V.)n =P- ∑𝑛𝑖=0 𝑑𝑖
(ii) (B.V.)n= 𝑃 − (𝑃 − 𝑆) × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑒𝑣𝑒𝑟𝑠𝑒
(iii) (B.V.)n= P - Dn

Numericals – SYD method

Q1 Repeat previous question with SYD?

Q2 Calculate total depreciation amount at the end of eight year

Q3 Calculate depreciation amount in the eight year?
Q4 Calculate Book Value amount at the end of eight year

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Declining Balance (D.B.)Method

• The important feature of this method is that salvage value is not zero.
• In this method, depreciation charge for any years can easily be calculated by multiplying
the fixed percentage of salvage value to the book value of that time.
• Depreciation for any year can also be solved by using formula:
dn = 𝐾 × (𝐵.𝑉.)n-1
Where,
𝟏
𝑺
K= Depreciation rate = 1 − ( 𝑷 )𝑵

N = Total life
Also, (𝐵.𝑉.)n = 𝑃 X (1 − 𝐾)n

Numerical – DB method
Q) If P = $20,000, salvage value = $350, useful life = 8 years. Using declining balance,
tabulate depreciation and BV at the end of each year.
Double Declining Balance Method (D.D.B.)

 In this method depreciation charge is permitted double or 200% of the straight line rate
1
 Rate of depreciation in straight line method is 𝑁
𝟐
 Rate of depreciation in DDB method is K = 𝑵

 Rest is same as declining balance method

𝟐
Dn = K (B.V.)n-1 = 𝑵 (B.V.)n-1

(B.V.)n = P (1-K)n = P - Dn

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Note :
 In 150% Declining balance method
𝟏.𝟓
K= 𝑵

1.5
Dn = K (B.V.)n-1 = (B.V.)n-1
𝑁

B.V.n = P (1-K)n = P - Dn

Numerical (DDB and 150% DB method)

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Declining Balance with switch over to straight line method

• Because the DB method never reaches a B.V. of ZERO, it is permissible to switch from
this method . So that an asset’s (B.V.)n will be ZERO.
• Also this method is used in calculating the MACRS recovery rate (shown in Table 7.3)

Numerical :

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Modified Accelerated Cost Recovery Method (MACRS)

• MACRS applies to most tangible depreciable property.

• Under MACRS, however, SV is defined to be zero, and useful life estimates are not used
directly in calculating depreciation amounts.
• Under MACRS, tangible depreciable property is categorized(organized) into asset
classes.
• The recovery rates for the six personal property classes that we will use in our
depreciation calculations are listed in Table7-3 (16th Edition Sullivan).
• MACRS determines annual depreciation amounts using the relation
𝐷n = 𝑑t X P

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

Computation method
1. The 3-, 5-, 7-, and 10-year classes use 200% D.B. and the 15- and 20-year classes use
150% declining balance depreciation.
2. All classes convert to straight-line depreciation in the optimal year, shown with asterisk
(*).
3. A half-year of depreciation is allowed in the first and last recovery years. i.e; The first
and last years of the recovery period are each assumed to be half-year
4. Salvage values are assumed to be zero for all assets.
5. If more than 40% of the year's MACRS property is placed in service in the last 3 months,
then a mid quarter convention must be used with depreciation tables that are not
shown here.

Numerical
Consider a 5-yearMACRSproperty asset with an installed and "made ready for use" cost
basis of $100.
Develop the MACRS percentage rates (rt) for the asset based on the underlying depreciation
methods.

Explanation
• To develop the 5-year MACRS property percentage rates, we use the 200% declining
balance method, switching over to straight line at the optimal point.
• Since the assumed salvage value is zero (S=0), the entire cost basis of $100 (P=100) is
depreciated.
• Let's explain the accompanying table year by year.
• In Year 1 the basis is ($100 – 0), and the di values are halved for the initial half-year
assumption.
• Double declining balance has the larger value, so it is chosen. Since N = 5, the rest of the
declining balance computations are simply 200% / 5 times the basis minus the
cumulative depreciation.

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Applied Economics for Engineers Prepared by Dr. Kashif Noor

• In Year 2 there are 4.5 years remaining for straight line, so 4.5 is the denominator for
dividing the remaining $80 in book value
• Similarly in Year 3 there are 3.5 years remaining.
• In Year"4”, the two calculations happen to be identical, so the switch from DDB to SL
can be done either in Year 4 or Year 5.
• Once we know that the SL depreciation is 11.52 at the switch point, then the only
further calculation is to halve that for the last year.
• Notice, that the DDB calculations get smaller every year, so that at some point the
straight-line calculations lead to faster depreciation. This point is the optimal switch
point

Numerical :
Recovery period = 5 years
Cost basis = P=17000
Yearly Depreciation = ?
Book value at the end of each year = ?
By MACRS method

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