Page 279 - Analysis, Synthesis and Design of Chemical Processes, Third Edition

The amount and rate at which equipment may be depreciated are set by the federal government (Internal
Revenue Service of the U.S. Treasury Department). The regulations that cover the capital depreciation
change often. Both the current method of depreciation suggested by the IRS and several of the techniques
that have been used in the past to depreciate capital investment are presented. Example 9.20 illustrates the
need for depreciation of capital.

Example 9.20

Consider a person who owns a business with the following annual revenue and expenses:

The owner of the business decides that, in order to improve the manufacturing operation, she must buy a
new packing and labeling machine for $100,000, which has a useful operating life of four years and can
be sold for $2000 scrap value at that time. This, she estimates, will increase her sales by 5% per year.

The only additional cost is an extra $1000/yr in utilities. The new, before-tax profit is estimated to be

Before-Tax Profit = $150,000 + 17,800 – 1000 = $ 166,800/yr, or an increase of $16,800/yr

Using a before-tax basis, it can be seen that her $100,000 investment yields $16,800/yr. The alternative to
buying the new machine is to invest money in a mutual fund that yields 10% per year before tax. At face
value, the investment in the new machine looks like a winner. However, take a close look at the cash
flows for each case (Table E9.20).

Table E9.20 Cash Flows for Both Investment Opportunities

Although the yearly return for buying the machine looks much better than that for the investment in the
mutual fund, the big difference is that at the end of the fourth year the owner can recover her initial

investment from the mutual fund, but the machine is worth only $2000. From this example, it can be seen
that the $100,000 – $2000 = $98,000 investment in the machine is really a long-term expense, and the
owner should be able to deduct it as a legitimate operating expense. Depreciation is the method that the
government allows for businesses to obtain operating expense credits for capital investments.