Earnings depreciation

For any company the earnings, depreciation allowance, bonds outstanding, and stock value can be obtained from its annual report to the stockholders. 

The Pressure of Capital. Today a major challenge is that some provision must be made to absorb the monies which have become available as a result of prosperous years of operation. Most companies find themselves in the position of having money to spend and too few ideas on which to spend it. The supply of money is generated from earnings, depreciation, and amortization. A well-run industrial concern has two choices. It can either pass these monies on to the stockholder as dividends or use them in capital expansion, conserving and multiplying them. To protect and increase the value of stockholder investments the favorability of the second choice is obvious, and the pressure to expand becomes so great that companies may often invest... 

Book-Bas s Depreciation. The book-basis depreciation is arbitrarily determined by management on a year-to-year basis, subject to acceptable accounting practice. This is not an out-of-pocket expense. It is simply a charge for the recovery of capital ia earnings calculations and is available as capital for reinvestment or distribution. Some consistent treatment for recovery of capital must be assumed ia profitabiUty analysis. 

In the fourth case, a plant or a piece of equipment has a limited use-Ril life. The primary reason for the decrease in value is the decrease in future life and the consequent decrease in the number of years for which income will be earned. At the end of its life, the equipment may be worth nothing, or it may have a salvage or scrap value S. Thus a fixed-capital cost Cpc depreciates in value during its useful life of s years by an amount that is equal to (Cpc S). The useful life is taken from the startup of the plant. 

When (NPV) and (DCFRR) are computed, depreciation is not considered as a separate expense. It is simply used as a permitted writing-down allowance to reciuce the annuaJ amount of tax in accordance with the rules applying in the country of earning. The tax payable is deducted in accordance with Eq. (9-2) in the year in which it is paid, which may differ from the year in which the corresponding income was earned. 

Inflation depreciates money in a manner similar to, but different from, the idea of discounting to allow for the time value of money. The effect of inflation on the net cash flow in future years can be allowed for in a similar manner to the net present worth calculation given by equation 6.9, using an inflation rate in place of, or added to, the discount rate r. However, the difficulty is to decide what the inflation rate is likely to be in future years. Also, inflation may well affect the sales price, operating costs and raw material prices differently. One approach is to argue that a decision between alternative projects made without formally considering the effect of inflation on future earnings will still be correct, as inflation is likely to affect the predictions made for both projects in a similar way. 

A company is considering which of two plants to build. Both plants cost 25,000,000. They will each earn pretax profits of 7,000,000 a year after 5 years of operation. The pretax profits (these do not include any depreciation expenses) of each plant are as follows ... 

A company needs 300,000,000 for capital expansions in the coming year. This will be obtained from the following sources at the following cost of money Retained earnings and depreciation allowances 140,000,000... 

The determination of the present value for the depreciation plans is one of the best ways of comparing depreciation plans. In calculating the present value it will be assumed that depreciation expenses remain in the company and effectively reduce income taxes. If the income tax rate on earnings is 48%, then the amount of income tax saved when depreciation expenses are increased by 100 is 48. Therefore, the net savings of including depreciation as an expense is 48% of all depreciation. If the net salvage value is less than the book value after depreciation, the difference is an income and is subject to taxation. Since the amount will be the same for each of the depreciation schemes, it will not be considered in comparing the different methods. 

A plant costs 14,000,000 and has a salvage value of 2,000,000 and a net salvage value of 1,000,000. The expected life of the plant is 8 years. Calculate the present value for the depreciation plans presented in this chapter. Assume that the interest rate is 10% and the income tax rate is 48% of all earnings. 

The answers obtained in Example 1 1-6 are typical of those usually obtained. If earnings are the only consideration, the straight-line depreciation method is the worst plan to use. However, the present values for the other methods are generally so close that no obviously best one can be picked. 

But earnings are not the only consideration. In 1968 the Union Carbide Corporation, along with many other companies, had a very bad year financially. In order to make its financial picture look better it switched from the double declining balance method of depreciation to the straight-line method. This reduced expenses (deprecitation being considered an expense) and hence increased profits. This is a semipermanent move, however, since a return to the double declining balance method would require approval of the Internal Revenue Service. 

These indications lead to detailed investigations of the processes, e.g., from a financial perspective this might be revenue, contribution margin and earnings before interests, taxes, depreciation and amortization (EBITDA) of certain product groups and customers, cost analysis for specific processes, overall equipment efficiency or research and development costs. 

The reconciliation between the cash flow statement and the income and expense statement is as follows. Start with the 40,000 from the last line in the cash flow statement, subtract 20,000 for the depreciation expense, and add back the 30,000 mortgage loan principal payment (not an allowed expense). The result is the net after-tax earnings. Figure B.ll is a set of statements from a small oil company. The statement of operations lists revenue and expenses, whereas the balance sheet lists various assets, liabilities, and stockholders equity ( net worth ). So-called capital items such as buildings, equipment, oil and gas property, and various intangibles are assets. Operating costs are deductions from revenues for operations not including expenditures for capital items. 

Gross margin/EBITDA (1) Earnings before interests, tax, amortization, depreciation also contribution margin I (CM I)... 

Resource value fixed production costs cfc, Vr e i in the resource-specific currency are input data not decision-relevant for optimization, but being used in order to calculate earnings before tax profits. Production fixed costs include the value depreciation of the resource, shift personnel costs and other fixed production-related cost blocks. 

Neither of these methods makes provision for including land and working capital, and no consideration is given to cash flows that occur in a project s later years after the depreciable fixed investment has been recovered for projects that earn most of their profit in the early years. 

Internal funds Capital available from depreciation and accumulated retained earnings. 

EBITDA Earnings before interests, taxes, amortization, and depreciation... 

The payback period(or payout time) is the number of years from plant start-up required to recover all expenses involved in a project, if all the pre-tax profits were used for this purpose. Depreciation charges are not included in the operating costs. Expenses not incurred directly in the design and construction of the plant are excluded, the analysis is intended to demonstrate the best means of allocating the present and future resources of a company. A payback period of less than five years is usually required for a project to proceed. However, the payback period does not consider the timing of the payments or the profits earned by the plant after the payback period. 

Annual cash flow. The annual cash flow (ACF) is the sum of the earnings after taxes and the depreciation for a one-year period. 

Since all physical assets of an industrial facility decrease in value with age, it is normal practice to make periodic charges against earnings so as to distribute the first cost of the facility over its expected service life. This depreciation expense as detailed in Chap. 9, unlike most other expenses, entails no current outlay of cash. Thus, in a given accounting period, a firm has available, in addition to the net profit, additional funds corresponding to the depreciation expense. This cash is capital recovery, a partial regeneration of the first cost of the physical assets. 

Profits earned hut not distributed to stockholders as dividends Depreciation funds set aside... 

Because Federal income taxes are based on gross earnings, which means that all costs have been deducted, the U.S. Treasury Department has devoted considerable effort to controlling one of the major costs in industrial operations, i.e., the cost for depreciation. The subject of depreciation costs is considered in Chap. 9, where some of the tax regulations by the U.S. Treasury Department are discussed. 

In determining the influence of depreciation costs on income taxes, it should be clear that depreciation costs represent a deduction from taxable gross earnings. Thus, if d is the depreciation cost for the year and 4> is the fractional... 

Consideration of depreciation as a cost permits realistic evaluation of profits earned by a company and, therefore, provides a basis for determination of Federal income taxes. Simultaneously, the consideration of depreciation as a cost provides a means whereby funds are set aside regularly to provide recovery of the invested capital. When accountants deal with depreciation, they must follow certain rules which are established by the U.S. Bureau of Internal Revenue for determination of income taxes. These rules deal with allowable life for the depreciable equipment and acceptable mathematical procedures for allocating the depreciation cost over the life of the asset. 

Taxation of export income and income earned abroad Tax incentives for new businesses Depreciation rates... 

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