Depreciation, Inflation, and After-Tax Cash Flow Analysis

Vocabulary practice flashcards covering depreciation methods, asset life standards, inflation and interest rate relationships, tax shields, and after-tax cash flow analysis.

Depreciation

The gradual decrease in the value of a tangible asset over time, or the systematic method of allocating the cost of a physical asset over its estimated useful life.

Obsolescence

The loss of asset value that occurs when the property becomes outdated or no longer technologically useful.

Deterioration

The physical process in which an asset wears out or loses effectiveness over time while being used for its intended purpose, failing to perform as well as when first purchased.

Depreciable Asset Requirements

The criteria an asset must satisfy to be depreciated: it must have a determinable useful life of more than one year, be used for business or income-generating purposes, and wear out over time (excluding assets like land).

Book Value ($BV$)

The accounting value of an asset calculated as its original cost basis minus accumulated depreciation to date, as recognized by tax authorities such as the Bureau of Internal Revenue (BIR).

Market Value ($MV$)

The amount of money realized if an asset is sold on the open market, representing the price agreed upon by a willing buyer and a willing seller.

Adjusted Cost Basis

An asset's original cost basis used to compute depreciation deductions, modified over time by allowable increases or decreases.

Salvage Value ($F$)

The estimated future or residual value of a property or asset at the end of its useful life.

Useful Life ($n$)

The recovery period or total number of years over which a business is permitted to depreciate an asset, as established by authorities like the BIR or COA.

Commission on Audit Circular No. 2003-007

The regulatory circular issued by the Commission on Audit (COA) specifying the estimated useful life standards for public property, plant, and equipment.

Straight-Line Method

The simplest depreciation method, which assumes a constant depreciation expense each year, calculated as $\text{Annual Depreciation} = \frac{P - F}{n}$.

Declining Balance Method

An accelerated depreciation method, also known as the Constant-Percentage Method or Matheson Formula, which applies a fixed percentage rate ($K$) to the asset's beginning-of-year book value.

Sum-of-the-Years-Digits Method (SOYD)

An accelerated depreciation technique based on the premise that assets are more productive when new, allocating depreciation each year using the formula $\left(\frac{\text{Years remaining}}{\text{SOYD}}\right)(P - F)$, where $\text{SOYD} = \frac{n(n + 1)}{2}$.

Sinking Fund Method

A depreciation method in which equal periodic funds ($A$) accumulate with interest to provide for asset replacement, where $A = \frac{(P - F)(i)}{(1 + i)^n - 1}$.

Working Hours Method

A depreciation technique, also known as the Service Output Method, that allocates cost basis per hour of use using the formula $\frac{P - F}{\text{Total Number of Hours}}$.

Constant Unit Method

An output-based depreciation technique that computes depreciation per unit produced using the formula $\frac{P - F}{\text{Total Number of Units}}$.

Inflation

The economic phenomenon that causes money to lose purchasing power over time, making future dollars less valuable than present dollars.

Purchasing Power

The quantitative capacity of a unit of money to buy goods and services, which deteriorates in an inflationary environment.

Constant-Value Dollars

Theoretical dollars whose purchasing power is assumed not to change over time, used in baseline economic cash flow analyses.

Inflation Rate ($f$)

The annual percentage increase in the number of dollars required to purchase the same basket of goods or services, averaging $2\%$ to $3\%$ per year in the United States.

Real Interest Rate ($i'$)

The interest rate that measures the true increase in purchasing power from an investment after removing the effect of inflation.

Market Interest Rate ($i$)

The nominal interest rate advertised in the marketplace and by banks for loans and savings accounts, which incorporates both the real interest rate and inflation.

Negative Real Interest Rate

A condition occurring when the inflation rate exceeds the nominal market interest rate, causing an investor to experience a net loss in real purchasing power (such as a $-2.3\%$ real rate from a $5.5\%$ market rate under $8\%$ inflation).

Actual Dollars vs. Real Dollars

Two dollar paradigms in engineering economy: actual dollars represent nominal transactions associated with market interest rates ($i$), whereas real dollars reflect constant purchasing power associated with real interest rates ($i'$).

Non-Cash Expense

A paper expense, such as depreciation, that reduces accounting profit and taxable income without requiring an actual outflow of cash.

Depreciation Tax Shield

The cash savings generated when depreciation reduces taxable income, calculated as $\text{Depreciation} \times \text{Tax Rate}$.

After-Tax Cash Flow

The actual net cash flow generated by a project after settling taxes and incorporating the depreciation benefit, calculated as $\text{Pre-tax Operating Profit} \times (1 - \text{Tax Rate}) + \text{Depreciation Tax Shield}$.

Cash Flow Conversion Formula

The financial formula used to reconcile net accounting income to operating cash movement: $\text{Cash Flow} = \text{Net Income} + \text{Depreciation}$.

Taxable Gain

The amount by which the sale price (salvage proceeds) of an asset exceeds its remaining book value at the time of disposal, subject to income tax.

After-Tax Salvage Value

The net cash retained from selling an asset after deducting the tax on the taxable gain, given by $\text{Sale Price} - \text{Tax on Gain}$.

Accelerated Depreciation Tax Effect

The front-loading of depreciation deductions into the early years of an asset's life, creating larger early tax shields that increase the Net Present Value (NPV) of a project.

Net Present Value (NPV)

The discounted sum of all future after-tax cash flows minus the initial investment cost, where a positive value indicates that an engineering project is financially viable.