Management Consulting/Finanacial analysis and industrial Financing
Good Evening Sir
1.''Return on investments is a single comprehensive measure that contains everything happening within the organization.''Explain this statement and illustrate its computations with imaginary figures.
2.''The true funds flow from depreciation is the opportunity saving of cash outflow through taxation.''Illustrate with a numerical example.
3.''stock market prices reflect the mass psychology with little if any connection with the exists economic values.''comment.
4.Are you in favour of nationalization of commercial banks in india?If yes,give the analysis of the performance of commercial banks.if no justify your views.
HERE IS SOME SOME USEFUL MATERIAL.
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1.''Return on investments is a single comprehensive measure that contains everything happening within the organization.''Explain this statement and illustrate its computations with imaginary figures.
Return on Investment (ROI) is the calculated benefit that an organization is projected to receive in return for investing money (resources) in a project within the context of the review process. The investment would be in an information system development or enhancement project. ROI information is used to assess the status of the business viability of the project at key check points throughout the project’s life-cycle.
ROI may include the benefits associated with improved mission performance, reduced cast, increased quality, speed, or flexibility, and increased customer and employee satisfaction. ROI should reflect such risk factors as the project’s technical complexity. The agency’s management capacity, the likelihood of cost overruns, and the consequences of under – or non-performance where appropriate, ROI should be reflect actual returns observed through pilot projects and prototypes.
ROI should be quantified in terms of dollors and should include a calculation of the break-even point (BEP) which is the date when the investment begins to generate a positive return. ROI should be re-calculated at every major checkpoint of a project to see if the BEP is still on schedule, based on project spending and accomplishments to date. If the project is behind schedule or over budget, the BEP may move out in time; if the project is ahead of or under budget the BEP may occur earlier. In either case, the information is important for decision-making based on the value of the investment throughout the project life-cycle.
Any project that has developed a business case is expected to fresh the ROI at each key project decision point (i.e. stage exist) or at least yearly
return on investment
Another fundamental financial and business performance measure. This term means different things to different people (often depending on perspective and what is actually being judged) so it's important to clarify understanding if interpretation has serious implications. Many business managers and owners use the term in a general sense as a means of assessing the merit of an investment or business decision. 'Return' generally means profit before tax, but clarify this with the person using the term - profit depends on various circumstances, not least the accounting conventions used in the business. In this sense most CEO's and business owners regard ROI as the ultimate measure of any business or any business proposition, after all it's what most business is aimed at producing - maximum return on investment, otherise you might as well put your money in a bank savings account. Strictly speaking Return On Investment is defined as:
Profits derived as a proportion of and directly attributable to cost or 'book value' of an asset, liability or activity, net of depreciation.
In simple terms this the profit made from an investment. The 'investment' could be the value of a whole business (in which case the value is generally regarded as the company's total assets minus intangible assets, such as goodwill, trademarks, etc and liabilities, such as debt. N.B. A company's book value might be higher or lower than its market value); or the investment could relate to a part of a business, a new product, a new factory, a new piece of plant, or any activity or asset with a cost attached to it.
The main point is that the term seeks to define the profit made from a business investment or business decision. Bear in mind that costs and profits can be ongoing and accumulating for several years, which needs to be taken into account when arriving at the correct figures.
Return on investment (ROI) is a term used in the financial industry to describe the monetary gain made by investing in some type of financial vehicle. There are a variety of financial vehicles that can be used to gain a reasonable return on investment. Stocks and bonds are typically what are thought of when considering investing; however, other vehicles, such as small business loans, precious metals, and credit transactions, can also provide reasonable rates of return on investment. An investor simply needs to understand how to calculate and monitor his or her investment and return rates.
Typically, return on investment is determined by dividing the amount of financial return from a specific investment vehicle by the total amount of monetary backing provided initially. For example, if an investor invested $20 US Dollars (USD) and got a return of $15 USD, then he or she would divide 15 by 20 to get 0.75 or a 75% rate of return. The higher the rate of return, the greater amount of money an investor is receiving as either dividend returns or cash returns.
Dividend returns are a specific type of ROI that entail all investors getting a guaranteed return on investment based on the success of the company and regardless of investment amount. As an example, a particular company may have a very successful year, and thus wants to extend dividend offerings of 1% of 10% of all profits to each investor. Therefore, each investor receives the same amount of return for investing in the company.
Cash returns are similar to dividend returns; however, each investor gets a different rate of return based on the amount of investment, also known as shares, they provided. For instance, if a share of a particular company is valued at $5 USD on the open market, and an investor purchases 100 shares at $500 USD but two weeks later the shares are worth $600 USD, that particular investor has a rate of return of 20% and a cash return of $100 USD. An investor who only purchased $100 USD worth of stock, however, will still get a 20% return, but only gain $20 USD cash return.
ROI = RETURN ON INVESTMENT ANALYSIS
COVERS A NUMBER OF ELEMENTS, WHICH INCLUDE
A stern measure of a company's ability to pay its short term debts, in that stock is excluded from asset value. (liquid assets/current liabilities) Also referred to as the Quick Ratio.
Anything owned by the company having a monetary value; eg, 'fixed' assets like buildings, plant and machinery, vehicles (these are not assets if rentedand not owned) and potentially including intangibles like trade marks and brand names, and 'current' assets, such as stock, debtors and cash.
Measure of operational efficiency - shows how much revenue is produced per £ of assets available to the business. (sales revenue/total assets less current liabilities)
The Balance Sheet is one of the three essential measurement reports for the performance and health of a company along with the Profit and Loss Account and the Cashflow Statement. The Balance Sheet is a 'snapshot' in time of who owns what in the company, and what assets and debts represent the value of the company. (It can only ever nbe a snapshot because the picture is always changing.) The Balance Sheet is where to look for information about short-term and long-term debts, gearing (the ratio of debt to equity), reserves, stock values (materials and finsished goods), capital assets, cash on hand, along with the value of shareholders' funds. The term 'balance sheet' is derived from the simple purpose of detailing where the money came from, and where it is now. The balance sheet equation is fundamentally: (where the money came from) Capital + Liabilities = Assets (where the money is now). Hence the term 'double entry' - for every change on one side of the balance sheet, so there must be a corresponding change on the other side - it must always balance. The Balance Sheet does not show how much profit the company is making (the P&L does this), although pervious years' retained profits will add to the company's reserves, which are shown in the balance sheet.
In a financial planning context the word 'budget' (as a noun) strictly speaking means an amount of money that is planned to spend on a particularly activity or resource, usually over a trading year, although budgets apply to shorter and longer periods. An overall organizational plan therefore contains the budgets within it for all the different departments and costs held by them. The verb 'to budget' means to calculate and set a budget, although in a looser context it also means to be careful with money and find reductions (effectively by setting a lower budgeted level of expenditure). The word budget is also more loosely used by many people to mean the whole plan. In which context a budget means the same as a plan. For example in the UK the Government's annual plan is called 'The Budget'. A 'forecast' in certain contexts means the same as a budget - either a planned individual activity/resource cost, or a whole business/ corporate/organizational plan. A 'forecast' more commonly (and precisely in my view) means a prediction of performance - costs and/or revenues, or other data such as headcount, % performance, etc., especially when the 'forecast' is made during the trading period, and normally after the plan or 'budget' has been approved. In simple terms: budget = plan or a cost element within a plan; forecast = updated budget or plan. The verb forms are also used, meaning the act of calculating the budget or forecast.
The value of all resources available to the company, typically comprising share capital, retained profits and reserves, long-term loans and deferred taxation. Viewed from the other side of the balance sheet, capital employed comprises fixed assets, investments and the net investment in working capital (current assets less current liabilities). In other words: the total long-term funds invested in or lent to the business and used by it in carrying out its operations.
The movement of cash in and out of a business from day-to-day direct trading and other non-trading or indirect effects, such as capital expenditure, tax and dividend payments.
cost of debt ratio (average cost of debt ratio)
Despite the different variations used for this term (cost of debt, cost of debt ratio, average cost of debt ratio, etc) the term normally and simply refers to the interest expense over a given period as a percentage of the average outstanding debt over the same period, ie., cost of interest divided by average outstanding debt.
cost of goods sold (COGS)
The directly attributable costs of products or services sold, (usually materials, labour, and direct production costs). Sales less COGS = gross profit. Effetively the same as cost of sales (COS) see below for fuller explanation.
cost of sales (COS)
Commonly arrived at via the formula: opening stock + stock purchased - closing stock.
Cost of sales is the value, at cost, of the goods or services sold during the period in question, usually the financial year, as shown in a Profit and Loss Account (P&L). In all accounts, particularly the P&L (trading account) it's important that costs are attributed reliably to the relevant revenues, or the report is distorted and potentially meaningless. To use simply the total value of stock purchases during the period in question would not produce the correct and relevant figure, as some product sold was already held in stock before the period began, and some product bought during the period remains unsold at the end of it. Some stock held before the period often remains unsold at the end of it too. The formula is the most logical way of calculating the value at cost of all goods sold, irrespective of when the stock was purchased. The value of the stock attributable to the sales in the period (cost of sales) is the total of what we started with in stock (opening stock), and what we purchased (stock purchases), minus what stock we have left over at the end of the period (closing stock).
Cash and anything that is expected to be converted into cash within twelve months of the balance sheet date.
The relationship between current assets and current liabilities, indicating the liquidity of a business, ie its ability to meet its short-term obligations. Also referred to as the Liquidity Ratio.
Money owed by the business that is generally due for payment within 12 months of balance sheet date. Examples: creditors, bank overdraft, taxation.
The apportionment of cost of a (usually large) capital item over an agreed period, (based on life expectancy or obsolescence), for example, a piece of equipment costing £10k having a life of five years might be depreciated over five years at a cost of £2k per year. (In which case the P&L would show a depreciation cost of £2k per year; the balance sheet would show an asset value of £8k at the end of year one, reducing by £2k per year; and the cashflow statement would show all £10k being used to pay for it in year one.)
A dividend is a payment made per share, to a company's shareholders by a company, based on the profits of the year, but not necessarily all of the profits, arrived at by the directors and voted at the company's annual general meeting. A company can choose to pay a dividend from reserves following a loss-making year, and conversely a company can choose to pay no dividend after a profit-making year, depending on what is believed to be in the best interests of the company. Keeping shareholders happy and committed to their investment is always an issue in deciding dividend payments. Along with the increase in value of a stock or share, the annual dividend provides the shareholder with a return on the shareholding investment.
There are several 'Earnings Before..' ratios and acronyms: EBT = Earnings Before Taxes; EBIT = Earnings Before Interest and Taxes; EBIAT = Earnings Before Interest after Taxes; EBITD = Earnings Before Interest, Taxes and Depreciation; and EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization. (Earnings = operating and non-operating profits (eg interest, dividends received from other investments). Depreciation is the non-cash charge to the balance sheet which is made in writing off an asset over a period. Amortisation is the payment of a loan in instalments.
Assets held for use by the business rather than for sale or conversion into cash, eg, fixtures and fittings, equipment, buildings.
A cost which does not vary with changing sales or production volumes, eg, building lease costs, permanent staff wages, rates, depreciation of capital items.
The ratio of debt to equity, usually the relationship between long-term borrowings and shareholders' funds.
Any surplus money paid to acquire a company that exceeds its net tangible assets value.
Sales less cost of goods or services sold. Also referred to as gross profit margin, or gross profit, and often abbreviated to simply 'margin'. See also 'net profit'.
General term for what the business owes. Liabilities are long-term loans of the type used to finance the business and short-term debts or money owing as a result of trading activities to date . Long term liabilities, along with Share Capital and Reserves make up one side of the balance sheet equation showing where the money came from. The other side of the balance sheet will show Current Liabilities along with various Assets, showing where the money is now.
Indicates the company's ability to pay its short term debts, by measuring the relationship between current assets (ie those which can be turned into cash) against the short-term debt value. (current assets/current liabilities) Also referred to as the Current Ratio.
net assets (also called total net assets)
Total assets (fixed and current) less current liabilities and long-term liabilities that have not been capitalised (eg, short-term loans).
net current assets
Current Assets less Current Liabilities.
net present value (npv)
NPV is a significant measurement in business investment decisions. NPV is essentially a measurement of all future cashflow (revenues minus costs, also referred to as net benefits) that will be derived from a particular investment (whether in the form of a project, a new product line, a proposition, or an entire business), minus the cost of the investment. Logically if a proposition has a positive NPV then it is profitable and is worthy of consideration. If negative then it's unprofitable and should not be pursued. While there are many other factors besides a positive NPV which influence investment decisions; NPV provides a consistent method of comparing propositions and investment opportunities from a simple capital/investment/profit perspective. There are different and complex ways to construct NPV formulae, largely due to the interpretation of the 'discount rate' used in the calculations to enable future values to be shown as a present value. Corporations generally develop their own rules for NPV calculations, including discount rate. NPV is not easy to understand for non-financial people - wikipedia seems to provide a good detailed explanation if you need one.
Net profit can mean different things so it always needs clarifying. Net strictly means 'after all deductions' (as opposed to just certain deductions used to arrive at a gross profit or margin). Net profit normally refers to profit after deduction of all operating expenses, notably after deduction of fixed costs or fixed overheads. This contrasts with the term 'gross profit' which normally refers to the difference between sales and direct cost of product or service sold (also referred to as gross margin or gross profit margin) and certainly before the deduction of operating costs or overheads. Net profit normally refers to the profit figure before deduction of corporation tax, in which case the term is often extended to 'net profit before tax' or PBT.
See explanation under Cost of Sales.
p/e ratio (price per earnings)
The P/E ratio is an important indicator as to how the investing market views the health, performance, prospects and investment risk of a public company listed on a stock exchange (a listed company). The P/E ratio is also a highly complex concept - it's a guide to use alongside other indicators, not an absolute measure to rely on by itself. The P/E ratio is arrived at by dividing the stock or share price by the earnings per share (profit after tax and interest divided by the number of ordinary shares in issue). As earnings per share are a yearly total, the P/E ratio is also an expression of how many years it will take for earnings to cover the stock price investment. P/E ratios are best viewed over time so that they can be seen as a trend. A steadily increasing P/E ratio is seen by the investors as increasingly speculative (high risk) because it takes longer for earnings to cover the stock price. Obviously whenever the stock price changes, so does the P/E ratio. More meaningful P/E analysis is conducted by looking at earnings over a period of several years. P/E ratios should also be compared over time, with other company's P/E ratios in the same market sector, and with the market as a whole. Step by step, to calculate the P/E ratio:
Establish total profit after tax and interest for the past year.
Divide this by the number of shares issued.
This gives you the earnings per share.
Divide the price of the stock or share by the earnings per share.
This gives the Price/Earnings or P/E ratio.
profit and loss account (P&L)
One of the three principal business reporting and measuring tools (along with the balance sheet and cashflow statement). The P&L is essentially a trading account for a period, usually a year, but also can be monthly and cumulative. It shows profit performance, which often has little to do with cash, stocks and assets (which must be viewed from a separate perspective using balance sheet and cashflow statement). The P&L typically shows sales revenues, cost of sales/cost of goods sold, generally a gross profit margin (sometimes called 'contribution'), fixed overheads and or operating expenses, and then a profit before tax figure (PBT). A fully detailed P&L can be highly complex, but only because of all the weird and wonderful policies and conventions that the company employs. Basically the P&L shows how well the company has performed in its trading activities.
An expense that cannot be attributed to any one single part of the company's activities.
Same as the Acid Test. The relationship between current assets readily convertible into cash (usually current assets less stock) and current liabilities. A sterner test of liquidity.
The accumulated and retained difference between profits and losses year on year since the company's formation.
return on capital employed (ROCE)
A fundamental financial performance measure. A percentage figure representing profit before interest against the money that is invested in the business. (profit before interest and tax, divided by capital employed, x 100 to produce percentage figure.)
The balance sheet nominal value paid into the company by shareholders at the time(s) shares were issued.
A measure of the shareholders' total interest in the company represented by the total share capital plus reserves.
A cost which varies with sales or operational volumes, eg materials, fuel, commission payments.
Current assets less current liabilities, representing the required investment, continually circulating, to finance stock, debtors, and work in progress.
Here are two formulas for calculating financial ROI for an IT project or any other investment. An example of how each formula is used is provided below.
simple roi = amount of financial gain/ total investment of amount.
discounted roi = net present value of benefits/ total present value of costs.
The simple ROI calculation is commonly used for short-term (e..g., less than one year) investments and benefits. It is uncomplicated and most people can understand it. For example, say $1,000 is invested and it earns $1,250. This is a gain of $250. Divide the $250 by $1,000 (the amount invested) gives an ROI of 25%.
However, the simple ROI calculation is less accurate when the investments and/or benefits involve future years because future dollars are worth less than current dollars. The general rule for greater accuracy is to use the discounted ROI calculation method when the investments and/or the benefits involve future years.
Information Required to Calculate ROI
A. Before the Investment : Measure the Baseline Performance
The planned improvement over present performance is what is important. Therefore, a BASELINE of current performance measurements must be established so a before-and-after comparison can be made.
Suitable measures of the performance that exists BEFORE the IT-enabled change can involve measures of cost, time, quality, flexibility, customer service, staffing and other factors. Any measure used must be expressed financially if it is to be included in a financial ROI calculation. (For example, a reduction in staff can be calculated in terms of annual dollar savings from salary, fringe benefits, and office overhead expenses. A reduction in staff turnover can be calculated in terms of cost savings in such areas as recruitment, training, production, and quality.)
B. After the Investment : Determine the Change in Performance
AFTER the IT-enabled change has been implemented, the performance needs to be measured to determine whether and how well the performance improved.
The same performance measures used to establish the baseline performance are used to measure the performance after the IT-enabled change—this is necessary so comparisons can be made.
The change in performance from the baseline that resulted from the IT investment is used to calculate the financial return on the investment.
Expect some complexity in arriving at the IT ROI result. For example, did all of the change in performance result from the IT project/investment? If not, your need to make a fair apportionment of the change caused by IT and the change caused by other factors. For example, a 35% improvement in performance might be partly due to a new incentive program that went into effect before the IT project was completed. A fair allocation might be that 10 percentage points can be attributed to the incentive program and 25 percentage points can be attributed to the IT project.
Examples of ROI Calculations
Comparing Simple and Discounted ROI Calculations for Company XYZ
Objective: Reduce the baseline cost of business process "A" by 25% or more and achieve a breakeven point (i.e., all costs have been recovered) by the end of the first year of operation and a cumulative ROI of 500% or greater is achieved by the end of the third year of operation.
Present (Baseline) Annual Cost of Business Process A (BPA) is $10 million
Investment in IT-Enabled Performance Improvement in BPA is $1 million
Amount of Time Required to Implement BPA Improvement is 6 Months
Benefits: Cost Savings For BPA After Implementation is $1 million in year 1 (because of only 6 months of benefits) and $3 million each in years 2 and 3.
Calculate the Simple and Discounted ROIs. This is done below. To simplify and make the concepts more understandable, the calculations assume that all investments and savings take place at the end of the year
Simple ROI Calculation Example
(Using the Formula Above)
$1 mill. benefit less $1 mill. investment = $0 divided by $1 mill. investment means that Simple ROI at the end of Year 1 = 0%
$4 mill.cumulative benefit less $1 mill. invest.= $3 mill net savings divided by $1 mill. invest. = 300%, which is the Cumulative Simple ROI at end of Year 2
$7 mill. cumulative benefit less $1 mill. invest. = $6 mill net savings divided by $1 mill. invest. = 600%, which is the Cumulative Simple ROI at end of Year 3
Because there is no discounting to reflect the time value of money, the results of the simple ROI calculation become increasingly less accurate the further it extends into future years.
Discounted ROI Calculation Example
(Using Formula Above)
This method takes into account the time value of money, the fact that a dollar received today is worth more than one received in a future year. This method is more complicated because we must first calculate the net present value of the costs and the net present value of the benefits and we must know the organization's discount rate to make these calculations. Then we can calculate the discounted ROI.
The example assumes that the annual discount rate used by Company XYZ is 6% (see your CFO for the figure your organization uses)
The table below shows the effect of a 6% discount rate on the present value of $1000 spent or received in future years. Note the formula (on the right side of the table) for calculating the present value figures in the table.
effective 6% discount rate
year-------amount spent---------------present value
This table can be used to determine the present value of $1000 spent or received in up to 7 future years. The table is in thousands.
Using Present Value Data to Calculate ROI
In the materials below, our example is in millions. We can simply move the decimal point three places to the right in any figure we take from the table for our calculations to take account of the shift from thousands to millions. PV stands for present value.
PV of Benefits: $1,000,000 received at end of year 1 = $943,400
PV of Investment: $1,000,000 paid at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($943,400 less $943,400) divided by $943,400 = 0% This is same as for the Simple ROI calculation because both all of the investment and all of the savings occurred at the same time in the first year.
PV of Benefits: $1,000,000 received at the end of year 1 ($943,400) and PV of another $3,000,000 received at the end of year 2 ($2,670,000) = $3,613,400
PV of Investments: $1,000,000 made at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($3,613,400 minus $943,400) divided by $943,400 = 2.830, or a cumulative ROI at the end of year 2 of 283%
Notice that the calculation for the Simple ROI shows 300%, which overstates the true (discounted) cumulative ROI by 17 percentage points.
PV of Benefits: $1,000,000 received at the end of year 1 ($943,400), PV of $3,000,000 received at the end of year 2 ($2,670,000), and PV of still another $3,000,000 received at the end of year 3 ($2,518,860) = $6,132,260
PV of Investments = $1,000,000 made at the end of year 1 = $943,400
(PV benefits less PV cost) divided by PV cost = ($6,132,260 minus $943,400) divided by $943,400 = 5.500, or a cumulative ROI at the end of year 3 of 550%
Notice that the calculation for the Simple ROI showed 600%, which overstates the true (discounted) cumulative ROI by 50 percentage points. An important point is that the Simple ROI calculation is always less and less accurate as the future years increase.
2.''The true funds flow from depreciation is the opportunity saving of cash outflow through taxation.''Illustrate with a numerical example.
Depreciation does not generate cash flow. If a million dollar piece of equipment is purchased, an accountant would reflect that the company now owns a million dollar asset. Without depreciation, the
company would still show a million dollar asset on the books even though we all know the equipment's value is decreasing. As such, the company's value would be overstated in the books.
- "Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will
reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes."Answer-The above answer is correct. This is an additional cash). Think about this - When you deduct depreciation from your profits, your net income figure gets reduced and if there is any distribution of cash which is based on net income, the amount of cash that is going out of cash within the business that could have gone out, had the depreciation not been done. Additional comment -And even more to add regarding the taxes thing (at least in Canada). Depreciation is not an allowable expense for calculating taxable income. What happens is that you add the depreciation that you expensed back, but then you are allowed to take a deduction for capital cost allowance (at specified rates for the particular class of is a a legit expense and is typical
done with straight line or MACRS.Additional comment -Regarding the first post: depreciation in accounting terms (amortization) is not meant to reflect the value of the asset. Rather, it is the gradual allocation of its cost to expense over its useful life.The fair market value of an asset may increase significantly over its original purchase price while at the same time its book value will decrease yearly due to depreciation.Strictly speaking, depreciation is a non-cash expense (no physical outflow of cash is involved). However, as mentioned above by others, it serves to reduce taxable income,
which, in turn, reduces the income tax paid
Business ownership costs
There are five ownership costs that every company incurs, namely: depreciation costs, interest costs, repair costs taxes, and insurance costs. They are commonly referred to as the "DIRTI 5".
This is a procedure for allocating the used up value of durable assets over the period they are owned by the business or until they are salvaged. By depreciating an asset, an allowance is made for the deterioration in the asset's value as a result of use (wear and tear), age and obsolescence. Generally, property is depreciable if it is used in business or to earn income;, wears out, decays, gets used up or becomes obsolete, and has a determinable useful life of more than one year. The proportion of the original cost to be depreciated in any one year is largely a matter of judgement and financial management. Normally, the depreciation allowance taken in any given year should reflect the actual decline in value of the asset - whether it is designed to influence income taxes or the undepreciated value of an asset reflecting the resale value of the asset.
There are four main and acceptable methods of calculating depreciation, namely:
• the accelerated cost recovery system (ACRS) method
• the straight line method
• the declining balance method
• the sum of the years-digits method.
The accelerated cost recovery system method is a relatively new method of calculating depreciation for tangible property. It came into use effectively in 1981. As a method ACRS generally gives much faster write off than other methods because it has tax savings as its primary objective. It usually gives little consideration to actual year-to-year change in value. Thus, for accounting purposes, other methods are more appropriate.
For tax purposes, property is classified as follows:-
i) 3 year property - automobiles and light-duty trucks used for business purposes and certain special tools, and depreciable property with a midpoint life of 4 years or less.
ii) 5 year property - most farm equipment, grain bins, single purpose structures and fences, breeding beef and dairy cattle, office equipment and office furniture.
iii) 10 year property- includes depreciable property with an expected life between 10 and 12.4 years.
iv) 15 year property - buildings.
The straight line method computes depreciation, Ds, as follows:
OC = Original cost or basis
SV = Salvage value
L = expected useful life of the asset in the business.
Declining balance method calculates depreciation as:-
Dd = RV x R
RV = undepreciated value of the asset at the start of the accounting period such that, in year 1, RV = OC, and in succeeding years,
RVi = [RVi-1 - Dd,i-1] x R (with salvage value not being deducted from original value before computing depreciation),
R = the depreciation rate, which may be up to twice the rate of decline, 1/L, allowed under straight line method.
Sum of the year-digits method estimates the depreciation of an asset as follows:-
RY = estimated years of useful life remaining
S = sum of the numbers representing years of useful life (i.e. for an asset with 5 years useful life, S would be 1+2+3+4+5 = 15).
5 Computation of depreciation
Using the straight line, declining balance, and sum of the year-digits methods, compute and tabulate the depreciation of a $1,000 asset with an estimated 10 years' life and projected salvage value of 10% of the original cost. (Assume for the declining balance method a depreciation rate calculated as 20% of the value at the beginning of the year. Usually the rate may not be greater than twice the rate which would be used under the straight line method).