The "Best" Tax Depreciation Method-1964

Abstract

IN THE October, 1961, issue of this Journal we outlined a capital budgeting technique for choosing the best method of tax depreciation.' In this note the analysis will be updated to reflect recent changes in the tax laws. The specific changes to be considered are the liberalization of the method of dealing with salvage values2 and the shortening of the service lives of many asset categories in the Guidelines.3 The basic elements of the choice problem have not changed. There are still two effective methods of accelerated depreciation, sum of the years-digits (hereinafter cited as SYD) and double declining balance (hereinafter cited as DDB). The firm is free to elect whichever method it prefers for each separate asset category; thus it may choose SYD for some assets and DDB for others. The best tax depreciation policy may still be defined as that method which provides the greatest present value for the tax deduction stream. The implementation of this decision criterion still requires considering three parameters: the asset's service life, its estimated salvage value, and the firm's cost of capital. And, finally, a convenient means for reducing the complexity of this three-parameter decision problem may still be offered by viewing one of the parameters, cost of capital, as the critical variable. The cost of capital may be treated as a variable by finding that discount rate which has the property of equating the present values of the SYD and DDB depreciation streams. This rate is equivalent to Irving Fisher's rate of return over cost.5 It represents the point of indifference between the two available accelerated depreciation methods. Because DDB always produces a greater depreciation charge in the first year of service life, it is clear that the DDB method will be preferable if the firm's cost of capital is greater than the indifference rate and that the SYD method is preferable at rates below the indifference point. This conclusion will be illustrated numerically later and a table will be presented summarizing the indifference rates for various combinations of service lives and salvage values. Under the new provisions for salvage value, the taxpayer is allowed to ignore salvage up to 10 per cent of the asset's original cost. Consider, for example, an asset costing $10,000, with a nine-year *Arthur Young Professor of Accounting and director of the Institute of Professional Accounting, Graduate School of Business, University of Chicago.