How Depreciation can Affect the Environment and Investment Decisions
How Depreciation can Affect the Environment and Investment Decisions
How Depreciation can Affect the Environment and Investment Decisions
The new buzz word in business today is green technology. The number of firms that have started in the last few years that work with green technology is staggering, from solar manufacturing to installation, to geo-thermal heating and cooling systems to LED lighting systems to solar hot water systems to firms that specialize in LEED administration. Both State and Federal Government has gotten involved, both offer incentives to use green technology. The federal government allows you to deduct the cost of the system from your taxes resulting in a lower tax burden, States offers vary but can also result in significant savings. Focusing on the Federal Incentive of reducing taxes brings in the tax accountants. The calculation of the tax savings from the purchase of the equipment is straight forward; if the system cost $1,000,000 you can receive a rebate of 30% of the cost of the system when you file your taxes or $300,000 in the above example. This deduction results in the actual cost of the system being $700,000. The return on the investment (ROI) is more attractive because of the cost of the system has been reduced. There is one other deduction the firm can take on the green system, it can be depreciated.
Depreciation is the using up of an asset over time; it is part of the matching principal of accounting that recognizes the use of an asset to produce income. The use of depreciation in calculating the ROI for a solar system can be substantial. There are two primary ways to calculate depreciation, straight line depreciation and double declining balance depreciation. The government in the Tax Reform Act of 1986 developed the Modified Accelerated Cost Recovery System (MACRS) which dictates the length of time you can use to calculate depreciation and solar systems are classified as 5 years. In both methods of calculating depreciation you need three pieces of information, the purchase price, the useful life and the salvage value. You know the purchase price at the start, the government has given you the useful life of 5 years and you know when the systems life is over there will not be any salvage value. Straight line depreciation takes the net between purchase price and salvage value and divides by the useful life, in our solar example you would depreciation $1,000,000 over 5 years or $200,000 a year, a 20% depreciation rate. The calculation for double declining balance utilizes the same information but allows you to depreciate the full value at the beginning, since our system will have no salvage value at the end this fact does not come into account in our calculations. The other difference is you can us double the straight line rate of depreciation or in our case 40%. Over the course of the 5 years both methods will result in a full depreciation of $1,000,000 but the double declining balance method allows you to take the deductions sooner.
For the tax advantages and based on the MACRS requirements all companies will use the double declining balance method of depreciation and follow the depreciation tables the IRS has developed. Since a dollar saved today will be worth more now than a dollar saved 5 years from now this methods provides tax saves as compared to the straight line depreciation. This is because it is expected that over the next 5 years there will be some inflation, whether it is 1% or 10% a year or somewhere in between, if the dollar you saved in year one was invested you would have more than the $1 saved in year 5. Using the solar example and comparing the two depreciation methods assuming a cost of money at an annual rate of 5% and a tax rate of 30% has the following affect on a solar systems' ROI.
Straight Line Depreciation would allow for a $200,000 a year write-off saving $60,000 in taxes, which in present values over the 5 years would be worth about $254,000 while using the double declining balance method the write off would be worth about $262,500. The extra $8,500 that is saved using the double declining method is about a 3.5% increase in the amount of tax savings. This savings increases the ROI of the $1,000,000 invested in the solar system by almost 1%.
The affect of using the tax credit for the solar system combined with the double depreciation write-off results in a true cost of net capital cost of $437,500 for a $1,000,000 system. If the system saved $50,000 a year in electric cost the ROI went from 5% to 7.14% with the tax credit to 11.4% with the depreciation write-off. Many firms would not invest the $1,000,000 for either the 5% or 7.14% return but would for an investment earning over 11%. Therefore the ability to utilize depreciation is helping to improve our environment.
Currently one of the problems with the governments' investment tax incentives is non-profit institutions, which do not have any taxes, cannot take advantage of either of these tax credits. This leaves them either working to try to sell off the tax credits which they will not be able to get a dollar for dollar sale or to only be able to compare the 5% ROI on an investment in a solar system.
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