ENERGY AUDITING & DEMAND SIDE MANAGEMENT

UNIT – VI ENERGY ECONOMIC

ANALYSIS
The time value of money concept, developing cash flow models, payback analysis,
depreciation, taxes and tax credit – numerical problems.
The time value of money concept
Money has time value. A rupee today is more valuable than a year hence. It is on
this concept “the time value of money” is based. The recognition of the time value
of money and risk is extremely vital in financial decision making.

REASONS FOR TIME VALUE OF MONEY

Money has time value because of the following reasons:
1. Risk and Uncertainty :Future is always uncertain and risky. Outflow of cash is in
our control as payments to parties are made by us. There is no certainty for future
cash inflows. Cash inflows is dependent out on our Creditor, Bank etc. As an
individual or firm is not certain about future cash receipts, it prefers receiving cash
now.
2. Inflation:In an inflationary economy, the money received today, has more
purchasing power than the money to be received in future. In other words, a rupee
today represents a greater real purchasing power than a rupee a year hence.
3. Consumption:Individuals generally prefer current consumption to future
consumption.
4. Investment opportunities:An investor can profitably emp loy a rupee received
today, to give him a higher value to be received tomorrow or after a certain p eriod
of time.
Thus, the fundamental principle behind the concept of time value of money is that,
a sum of money received today, is worth more than if the same is received after a
certain period of time. For example, if an individual is given an alternative either to
receive `10,000 now or after one year, he will prefer `10,000 now. This is because,
today, he may be in a position to purchase more goods with this money than what
he is going to get for the same amount after one year.
Thus, time value of money is a vital consideration in making financial decision.
Let us take some examples:
EXAMPLE 1:A project needs an initial investment of `1,00,000. It is exp ected to
give a return of `20,000 per annum at the end of each year, for six years. The
project thus involves a cash outflow of `1,00,000 in the ‘zero year’ and cash
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inflows of `20,000 per year, for six years. In order to decide, whether to accep t or
reject the project, it is necessary that the Present Value of cash inflows received
annually for six years is ascertained and compared with the initial investment of
`1,00,000. The firm will accept the project only when the Present Value of cash
inflows at the desired rate of interest exceeds the initial investment or at least
equals the initial investment of `1,00,000.
EXAMPLE2:A firm has to choose between two projects. One involves an outlay of
`10 lakhs with a return of 12% from the first year onwards, for ten years. The other
requires an investment of `10 lakhs with a return of 14% per annum for 15 years
commencing with the beginning of the sixth year of the project. In order to make a
choice between these two projects, it is necessary to compare the cash outflows
and the cash inflows resulting from the project. In order to make a meaningful
comparison, it is necessary that the two variables are strictly comp arable. It is
possible only when the time element is incorporated in the relevant calculations.
This reflects the need for comparing the cash flows arising at different p oints of
time in decision-making.
VALUATION CONCEPTS
The time value of money establishes that there is a preference of having money at
present than a future point of time. It means (a) That a person will have to p ay in
future more, for a rupee received today. For example: Suppose your father gave
you `100 on your tenth birthday. You deposited this amount in a bank at 10% rate
of interest for one year. How much future sum would you receive after one year?
You would receive `110
Future sum = Principal + Interest
= 100 + 0.10 × 100
= `110
What would be the future sum if you deposited `100 for two years? You would
now receive interest on interest earned after one year.
Future sum = 100 × 1.10
2 =`121

We express this procedure of calculating as Compound Value or Future Value of a

sum.
(b) A person may accept less today, for a rupee to be received in the future. Thus,
the inverse of compounding process is termed as discounting. Here we can find the
value of future cash flow as on today.
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TECHNIQUES OF TIME VALUE OF MONEY

There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques
The value of money at a future date with a given interest rate is called future value.
Similarly, the worth of money today that is receivable or payable at a future date is
called Present Value.
Compounding Techniques/Future Value Technique
In this concept, the interest earned on the initial principal amount becomes a part of
the principal at the end of the compounding period.
This process of compounding will continue for an indefinite time period.
The process of investing money as well as reinvesting interest earned there on is
called Compounding. But the way it has gone about calculating the future value
will prove to be cumbersome if the future value over long maturity p eriods of 20
years to 30 years is to be calculated. A generalized procedure for calculating the
future value of a single amount compounded annually.

FUTURE VALUE OF MULTIPLE CASH FLOWS

Developing cash flow models
Discounted cash flow
In finance, discounted cash flow (DCF) analysis is a method of valuing a project,
company, or asset using the concepts of the time value of money. All future cash
flows are estimated and discounted to give their present values (PVs) — the sum
of all future cash flows, both incoming and outgoing, is the net present value
(NPV), which is taken as the value or price of the cash flows in question.
Using DCF analysis to compute the NPV takes as input cash flows and a discount
rate and gives as output a price; the opposite process — taking cash flows and a
price and inferring a discount rate, is called the yield.
Discounted cash flow analysis is widely used in investment finance, real estate
development, and corporate financial management.
Discount rate
The most widely used method of discounting is exponential discounting, which
values future cash flows as "how much money would have to be invested currently,
at a given rate of return, to yield the cash flow in future." Other methods of

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discounting, such as hyperbolic discounting, are studied in academia and said to

reflect intuitive decision-making, but are not generally used in industry.
The discount rate used is generally the appropriate Weighted average cost of
capital (WACC), that reflects the risk of the cashflows. The discount rate reflects
two things:
1. The time value of money ( risk-free rate) – according to the theory of time
preference, investors would rather have cash immediately than having to
wait and must therefore be compensated by paying for the delay.
2. A risk premium – reflects the extra return investors demand because they
want to be compensated for the risk that the cash flow might not materialize
after all.
Discounted cash flows
The discounted cash flow formula is derived from the future value formula for
calculating the time value of money and compounding returns.
Thus the discounted present value (for one cash flow in one future period) is
expressed as:
where
• DPV is the discounted present value of the future cash flow (FV), or FV
adjusted for the delay in receipt;
• FV is the nominal value of a cash flow amount in a future period;
• i is the interest rate, which reflects the cost of tying up capital and may also
allow for the risk that the payment may not be received in full;
• d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a
deduction at the beginning of the year instead of an addition at the end of the
year;
• n is the time in years before the future cash flow occurs.
Where multiple cash flows in multiple time periods are discounted, it is necessary
to sum them as follows:

for each future cash flow (FV) at any time period (t) in years from the present time,
summed over all time periods. The sum can then be used as a net p resent valu e
figure. If the amount to be paid at time 0 (now) for all the future cash flows is

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known, then that amount can be substituted for DPV and the equation can be
solved for i, that is the internal rate of return.
All the above assumes that the interest rate remains constant throughout the whole
period.
Discounted cash flows
The discounted cash flow formula is derived from the future value formula for
calculating the time value of money and compounding returns.
Thus the discounted present value (for one cash flow in one future period) is
expressed as:
where
• DPV is the discounted present value of the future cash flow (FV), or FV
adjusted for the delay in receipt;
• FV is the nominal value of a cash flow amount in a future period;
• i is the interest rate, which reflects the cost of tying up capital and may also
allow for the risk that the payment may not be received in full;
• d is the discount rate, which is i/(1+i), i.e. the interest rate expressed as a
deduction at the beginning of the year instead of an addition at the end of the
year;
• n is the time in years before the future cash flow occurs.
Where multiple cash flows in multiple time periods are discounted, it is necessary
to sum them as follows:
for each future cash flow (FV) at any time period (t) in years from the present time,
summed over all time periods. The sum can then be used as a net p resent valu e
figure. If the amount to be paid at time 0 (now) for all the future cash flows is
known, then that amount can be substituted for DPV and the equation can be
solved for i, that is the internal rate of return.
All the above assumes that the interest rate remains constant throughout the whole
period.
Continuous cash flows
For continuous cash flows, the summation in the above formula is rep laced by an
integration:

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where FV(t) is now the rate of cash flow, and λ = log(1+i).

Example DCF
To show how discounted cash flow analysis is performed, consider the following
simplified example.
• John Doe buys a house for $100,000. Three years later, he expects to be able
to sell this house for $150,000.
Simple subtraction suggests that the value of his profit on such a transaction would
be $150,000 − $100,000 = $50,000, or 50%. If that $50,000 is amortized over the
three years, his implied annual return (known as the internal rate of return) would
be about 14.5%. Looking at those figures, he might be justified in thinking that the
purchase looked like a good idea.
1.145 3 x 100000 = 150000 approximately.
However, since three years have passed between the purchase and the sale, any
cash flow from the sale must be discounted accordingly. At the time John Doe
buys the house, the 3-year US Treasury Note rate is 5% per annum. Treasury
Notes are generally considered to be inherently less risky than real estate, since the
value of the Note is guaranteed by the US Government and there is a liquid market
for the purchase and sale of T-Notes. If he hadn't put his money into buying the
house, he could have invested it in the relatively safe T-Notes instead. This 5% per
annum can therefore be regarded as the risk-free interest rate for the relevant
period (3 years).
Using the DPV formula above (FV=$150,000, i=0.05, n=3), that means that the
value of $150,000 received in three years actually has a present value of $129,576
(rounded off). In other words we would need to invest $129,576 in a T -Bond now
to get $150,000 in 3 years almost risk free. This is a quantitative way of showing
that money in the future is not as valuable as money in the present ($150,000 in 3
years isn't worth the same as $150,000 now; it is worth $129,576 now).
Subtracting the purchase price of the house ($100,000) from the present value
results in the net present value of the whole transaction, which would be $29,576
or a little more than 29% of the purchase price.
Another way of looking at the deal as the excess return achieved (over the risk-free
rate) is (114.5 - 105)/(100 + 5) or approximately 9.0% (still very respectable).
But what about risk?
We assume that the $150,000 is John's best estimate of the sale price that he will be
able to achieve in 3 years time (after deducting all expenses, of course). There is of
course a lot of uncertainty about house prices, and the outcome may end up higher
or lower than this estimate.

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(The house John is buying is in a "good neighborhood," but market values have
been rising quite a lot lately and the real estate market analysts in the media are
talking about a slow-down and higher interest rates. There is a probability that
John might not be able to get the full $150,000 he is expecting in three years due to
a slowing of price appreciation, or that loss of liquidity in the real estate market
might make it very hard for him to sell at all.)
Under normal circumstances, people entering into such transactions are risk -
averse, that is to say that they are prepared to accept a lower expected return for the
sake of avoiding risk. See Capital asset pricing model for a further discussion of
this. For the sake of the example (and this is a gross simplification), let's assume
that he values this particular risk at 5% per annum (we could perform a more
precise probabilistic analysis of the risk, but that is beyond the scope of this
article). Therefore, allowing for this risk, his expected return is now 9.0% per
annum (the arithmetic is the same as above).
And the excess return over the risk-free rate is now (109 - 105)/(100 + 5) which
comes to approximately 3.8% per annum.
That return rate may seem low, but it is still positive after all of our discounting,
suggesting that the investment decision is probably a good one: it produces enough
profit to compensate for tying up capital and incurring risk with a little extra left
over. When investors and managers perform DCF analysis, the important thing is
that the net present value of the decision after discounting all future cash flows at
least be positive (more than zero). If it is negative, that means that the investment
decision would actually lose money even if it appears to generate a nominal profit.
For instance, if the expected sale price of John Doe's house in the examp le above
was not $150,000 in three years, but $130,000 in three years or $150,000 in five
years, then on the above assumptions buying the house would actually cause John
to lose money in present-value terms (about $3,000 in the first case, and about
$8,000 in the second). Similarly, if the house was located in an undesirable
neighborhood and the Federal Reserve Bank was about to raise interest rates by
five percentage points, then the risk factor would be a lot higher than 5%: it might
not be possible for him to predict a profit in discounted terms even if he thinks he
could sell the house for $200,000 in three years.
In this example, only one future cash flow was considered. For a decision which
generates multiple cash flows in multiple time periods, all the cash flows must be
discounted and then summed into a single net present value.
Payback analysis
Payback period in capital budgeting refers to the period of time required for the
return on an investment to "repay" the sum of the original investment. For
example, a $1000 investment which returned $500 per year would have a two year
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payback period. The time value of money is not taken into account. Payback
period intuitively measures how long something takes to "pay for itself." All else
being equal, shorter payback periods are preferable to longer payback periods.
Payback period is widely used because of its ease of use despite the recognized
limitations described below.
The term is also widely used in other types of investment areas, often with respect
to energy efficiency technologies, maintenance, upgrades, or other changes. For
example, a compact fluorescent light bulb may be described as having a p ayback
period of a certain number of years or operating hours, assuming certain costs.
Here, the return to the investment consists of reduced op erating costs. Although
primarily a financial term, the concept of a payback period is occasionally
extended to other uses, such as energy payback period (the period of time over
which the energy savings of a project equal the amount of energy exp ended since
project inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to ap ply and
easy to understand for most individuals, regardless of academic training or field of
endeavour. When used carefully or to compare similar investments, it can be quite
useful. As a stand-alone tool to compare an investment to "doing nothing,"
payback period has no explicit criteria for decision-making (except, p erhaps, that
the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not account for the time value of money,
risk, financing or other important considerations, such as the opportunity cos t.
Whilst the time value of money can be rectified by applying a weighted average
cost of capital discount, it is generally agreed that this tool for investment decisions
should not be used in isolation. Alternative measures of "return" preferred by
economists are net present value and internal rate of return. An implicit
assumption in the use of payback period is that returns to the investment continue
after the payback period. Payback period does not specify any required comparison
to other investments or even to not making an investment.
Payback period is usually expressed in years. Start by calculating Net Cash Flow
for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1.
Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 +
Net Cash Flow Year 3 ... etc.) Accumulate by year until Cumulative Cash Flow is a
positive number: that year is the payback year.
To calculate a more exact payback period: Payback Period = Amount to be
Invested/Estimated Annual Net Cash Flow 1
It can also be calculated using the formula:
Payback Period = (p - n)÷p + n y
= 1 + n y - n÷p (unit:years)
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Where
ny= The number of years after the initial investment at which the last negative
value of cumulative cash flow occurs.
n= The value of cash flow at which the last negative value of cumulative cash flow
occurs.
p= The value of cash flow at which the first positive value of cumulative cash flow
occurs.
This formula can only be used to calculate the soonest payback period; that is, the
first period after which the investment has paid for itself. If the cumulative cash
flow drops to a negative value some time after it has reached a positive value,
thereby changing the payback period, this formula can't be applied. This formula
ignores values that arise after the Payback Period has been reached.
Additional complexity arises when the cash flow changes sign several times; i.e., it
contains outflows in the midst or at the end of the project lifetime. The modified
payback period algorithm may be applied then. First, the sum of all of the cash
outflows is calculated. Then the cumulative positive cash flows are determined for
each period. The modified payback is calculated as the moment in which the
cumulative positive cash flow exceeds the total cash outflow.
Depreciation
In accountancy, depreciation refers to two aspects of the same concept:
1. The decrease in value of assets ( fair value depreciation), and
2. The allocation of the cost of assets to periods in which the assets are used
(depreciation with the matching principle).
The former affects the balance sheet of a business or entity, and the latter affects
the net income that they report. Generally the cost is allocated, as depreciation
expense, among the periods in which the asset is expected to be used. This expense
is recognized by businesses for financial reporting and tax p urposes. Methods of
computing depreciation, and the periods over which assets are dep reciated, may
vary between asset types within the same business. These may be specified by law
or accounting standards, which may vary by country. There are several standard
methods of computing depreciation expense, including fixed percentage, straight
line, and declining balance methods. Depreciation expense generally begins when
the asset is placed in service. For example, a depreciation expense of 100 p er year
for 5 years may be recognized for an asset costing 500.
Accounting concept

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In determining the profits (net income) from an activity, the receipts from the
activity must be reduced by appropriate costs. One such cost is the cost of as sets
used but not immediately consumed in the activity. Such cost so allocated in a
given period is equal to the reduction in the value placed on the asset, which is
initially equal to the amount paid for the asset and subsequently may or may not be
related to the amount expected to be received upon its disposal. Depreciation is any
method of allocating such net cost to those periods in which the organization is
expected to benefit from use of the asset. The asset is referred to as a dep reciable
asset. Depreciation is technically a method of allocation, not valuation, even
though it determines the value placed on the asset in the balance sheet.
Any business or income producing activity using tangible assets may incur costs
related to those assets. If an asset is expected to produce a benefit in future periods,
some of these costs must be deferred rather than treated as a current exp ense. The
business then records depreciation expense in its financial reporting as the current
period's allocation of such costs. This is usually done in a rational and systematic
manner. Generally this involves four criteria:
• cost of the asset,
• expected salvage value, also known as residual value of the asset,
• estimated useful life of the asset, and
• a method of apportioning the cost over such life
Depreciable basis
Cost generally is the amount paid for the asset, including all costs related to
acquisition. [5] In some countries or for some purposes, salvage value may be
ignored. The rules of some countries specify lives and methods to be used for
particular types of assets. However, in most countries the life is based on business
experience, and the method may be chosen from one of several acceptable
methods.
Net basis
When a depreciable asset is sold, the business recognizes gain or loss based on net
basis of the asset. This net basis is cost less depreciation.
Impairment
Accounting rules also require that an impairment charge or expense be recognized
if the value of assets declines unexpectedly. [6] Such charges are usually
nonrecurring, and may relate to any type of asset.
Depletion and amortization
Depletion and amortization are similar concepts for minerals (including oil) and
intangible assets, respectively. Depreciation expense does not require current
outlay of cash. However since depreciation is an expense to the P&L account,
provided the enterprise is operating in a manner that covers its expenses (e.g.
operating at a profit) depreciation is a source of cash in a statement of cash flows,
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which generally offsets the cash cost of acquiring new assets reuired to continue
operations when existing assets reach the end of their useful lives.
Historical cost
Depreciation is generally recognized under historical cost systems of accounting.
Some proposals for fair value accounting have no provision for depreciation
expense.
Accumulated depreciation
While depreciation expense is recorded on the income statement of a business, its
impact is generally recorded in a separate account and disclosed o n the balance
sheet as accumulated depreciation, under fixed assets, according to most
accounting principles. Accumulated depreciation is known as a contra account,
because it separately shows a negative amount that is directly associated with
another account.
Without an accumulated depreciation account on the balance sheet, dep reciation
expense is usually charged against the relevant asset directly. The values of the
fixed assets stated on the balance sheet will decline, even if the business has not
invested in or disposed of any assets. The amounts will roughly approximate fair
value. Otherwise, depreciation expense is charged against accumulated
depreciation. Showing accumulated depreciation separately on the balance sheet
has the effect of preserving the historical cost of assets on the balance sheet. If
there have been no investments or dispositions in fixed assets for the year, then the
values of the assets will be the same on the balance sheet for the current and p rior
[Link] other words it is a method of recovering capital expenditure in installments
which is called as depreciation.
Methods of depreciation
There are several methods for calculating depreciation, generally based on either
the passage of time or the level of activity (or use) of the asset.
Straight-line depreciation
Straight-line depreciation is the simplest and most often used method. In this
method, the company estimates the salvage value of the asset at the end of the
period during which it will be used to generate revenues (useful life). (The salvage
value is an estimate of the value of the asset at the time it will be sold or disp osed
of; it may be zero or even negative. Salvage value is also known as scrap value or
residual value.) The company will then charge the same amount to dep reciation
each year over that period, until the value shown for the asset has reduced from the
original cost to the salvage value.
Straight-line method:

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For example, a vehicle that depreciates over 5 years is purchased at a cost of

$17,000, and will have a salvage value of $2000. Then this vehicle will depreciate
at $3,000 per year, i.e. (17-2)/5 = 3. This table illustrates the straight-line method
of depreciation. Book value at the beginning of the first year of depreciation is the
original cost of the asset. At any time book value equals original cost minus
accumulated depreciation.
book value = original cost − accumulated depreciation Book value at the end of
year becomes book value at the beginning of next year. The asset is dep reciated
until the book value equals scrap value.
Accumulated
depreciation at
Book value at Depreciation Book value at beginning of year expense in year
end of year
end of year
$17,000
$3,000 $3,000 $14,000
(original cost)
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$2,000
$5,000 $3,000 $15,000
(scrap value)
If the vehicle were to be sold and the sales price exceeded the depreciated value
(net book value) then the excess would be considered a gain and subject to
depreciation recapture. In addition, this gain above the depreciated value would be
recognized as ordinary income by the tax office. If the sales price is ever less than
the book value, the resulting capital loss is tax deductible. If the sale price were
ever more than the original book value, then the gain above the original book value
is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the
tax office then this generates a timing difference in the income statement due to the
difference (at a point in time) between the taxation department's and comp any's
view of the profit.
Declining-balance method (or Reducing balance method)
Depreciation methods that provide for a higher depreciation charge in the first year
of an asset's life and gradually decreasing charges in subsequent years are called
accelerated depreciation methods. This may be a more realistic reflection of an
asset's actual expected benefit from the use of the asset: many assets are most
useful when they are new. One popular accelerated method is the declining-
balance method. Under this method the book value is reduced by a fixed
percentage each year.

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Depreciation in year = Depreciation rate * Book Value at start of year The

most common depreciation rate used is double the straight -line rate. For this
reason, this technique is sometimes referred to as the double-declining-balance
method. To illustrate, suppose a business has an asset with $1,000 original cost,
$100 salvage value, and 5 years of useful life. First, the straight-line dep reciation
rate would be 1/5, i.e. 20% per year. Under the double-declining-balance method,
double that rate, i.e. 40% depreciation rate would be used. The table below
illustrates this:
Book value at Depreciation Depreciation Accumulated Book value at
beginning of year rate expense depreciation end of year
$1,000
40% $400 $400 $600
(original cost)
$600 40% $240 $640 $360
$360 40% $144 $784 $216
$216 40% $86.40 $870.40 $129.60
$100
$129.60 $129.60 - $100 $29.60 $900
(scrap value)
When using the double-declining-balance method, the salvage value is not
considered in determining the annual depreciation, but the book value of the asset
being depreciated is never brought below its salvage value, regardless of the
method used. Depreciation ceases when either the salvage value or the end of the
asset's useful life is reached.
Since double-declining-balance depreciation does not always dep reciate an asset
fully by its end of life, some methods also compute a straight -line depreciation
each year, and apply the greater of the two. This has the effect of converting from
declining-balance depreciation to straight-line depreciation at a midpoint in the
asset's life.
With the declining balance method, one can find the depreciation rate that would
allow exactly for full depreciation by the end of the period, using the formula:

,
where N is the estimated life of the asset (for example, in years).
Activity depreciation
Activity depreciation methods are not based on time, but on a level of activity.
This could be miles driven for a vehicle, or a cycle count for a machine. When the
asset is acquired, its life is estimated in terms of this level of activity. Assume the
vehicle above is estimated to go 50,000 miles in its lifetime. The per -mile
depreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles =

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$0.30 per mile. Each year, the depreciation expense is then calculated by
multiplying the number of miles driven by the per-mile depreciation rate.
Sum-of-years-digits method
Sum-of-years-digits is a depreciation method that results in a more accelerated
write-off than the straight line method, and typically also more accelerated than the
declining balance method. Under this method the annual depreciation is
determined by multiplying the depreciable cost by a schedule of fractions.
depreciable cost = original cost − salvage value
book value = original cost − accumulated depreciation
Example: If an asset has original cost of $1000, a useful life of 5 years and a
salvage value of $100, compute its depreciation schedule.
First, determine years' digits. Since the asset has useful life of 5 years, the years'
digits are: 5, 4, 3, 2, and 1.
Next, calculate the sum of the digits: 5+4+3+2+1=15
The sum of the digits can also be determined by using the formula (n 2+n)/2 where
n is equal to the useful life of the asset in years. The example would be shown as
(52+5)/2=15
Depreciation rates are as follows:
5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th
year, and 1/15 for the 5th year.
Book value Total Book
at Depreciation Depreciation Accumulated value at
beginning of depreciable rate expense depreciation end of
year cost year
$1,000 *
(original $900 5/15 $300 ($900 $300 $700
cost) 5/15)
*
$700 $900 4/15 $240 ($900 $540 $460
4/15)
*
$460 $900 3/15 $180 ($900 $720 $280
3/15)
*
$280 $900 2/15 $120 ($900 $840 $160
2/15)
* $100
$160 $900 1/15 $60 ($900 $900 (scrap
1/15) value)

19 P. SURESH BABU, ASST. Prof., DEPT OF EEE

 ENERGY AUDITING & DEMAND SIDE MANAGEMENT (9A02808)

Units-of-production depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms
of the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is
expected to produce 6,000 units.
Depreciation per unit = ($70,000−10,000) / 6,000 = $10
10 × actual production will give the depreciation cost of the current year.
The table below illustrates the units-of-production depreciation schedule of the
asset.
Book value
Book value at Units of Depreciation Depreciation Accumulated
of
beginning production cost per unit expense depreciation at
year end of year
$70,000
(original 1,000 $10 $10,000 $10,000 $60,000
cost)
$60,000 1,100 $10 $11,000 $21,000 $49,000
$49,000 1,200 $10 $12,000 $33,000 $37,000
$37,000 1,300 $10 $13,000 $46,000 $24,000
$10,000
$24,000 1,400 $10 $14,000 $60,000 (scrap
value)
Depreciation stops when book value is equal to the scrap value of the asset. In the
end, the sum of accumulated depreciation and scrap value equals the original cost.
Composite depreciation method
The composite method is applied to a collection of assets that are not similar, and
have different service lives. For example, computers and printers are not similar,
but both are part of the office equipment. Depreciation on all assets is determined
by using the straight-line-depreciation method.
Asset Historical Salvage Depreciable Life Depreciation
cost value cost per year
Computers $5,500 $500 $5,000 5 $1,000
Printers $1,000 $100 $ 900 3 $ 300
Total $ 6,500 $600 $5,900 4.5 $1,300
Composite life equals the total depreciable cost divided by the total depreciation
per year. $5,900 / $1,300 = 4.5 years.

20 P. SURESH BABU, ASST. Prof., DEPT OF EEE

 ENERGY AUDITING & DEMAND SIDE MANAGEMENT (9A02808)

Composite depreciation rate equals depreciation per year divided by total

historical cost. $1,300 / $6,500 = 0.20 = 20%
Depreciation expense equals the composite depreciation rate times the balance in
the asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation
expense and credit accumulated depreciation.
When an asset is sold, debit cash for the amount received and credit the asset
account for its original cost. Debit the difference between the two t o accumulated
depreciation. Under the composite method no gain or loss is recognized on the sale
of an asset. Theoretically, this makes sense because the gains and losses from
assets sold before and after the composite life will average themselves out.
To calculate composite depreciation rate, divide depreciation per year by total
historical cost. To calculate depreciation expense, multiply the result by the same
total historical cost. The result, not surprisingly, will equal to the total depreciation
Per Year again.
Common sense requires depreciation expense to be equal to total depreciation p er
year, without first dividing and then multiplying total depreciation per year by the
same number.
Tax depreciation
Most income tax systems allow a tax deduction for recovery of the cost of assets
used in a business or for the production of income. Such deductions are allowed for
individuals and companies. Where the assets are consumed currently, the cos t may
be deducted currently as an expense or treated as part of cost of goods sold. The
cost of assets not currently consumed generally must be deferred and recovered
over time, such as through depreciation. Some systems permit full deduction of the
cost, at least in part, in the year the assets are acquired. Other systems allow
depreciation expense over some life using some depreciation method or
percentage. Rules vary highly by country, and may vary within a country based on
type of asset or type of taxpayer. Many systems that specify depreciation lives and
methods for financial reporting require the same lives and methods be used for ta x
purposes. Most tax systems provide different rules for real p roperty (buildings,
etc.) and personal property (equipment, etc.).
Capital allowances
A common system is to allow a fixed percentage of the cost of depreciable assets
to be deducted each year. This is often referred to as a capital allowance, as it is
called in the United Kingdom. Deductions are permitted to individuals and
businesses based on assets placed in service during or before the assessment year.
Canada's Capital Cost Allowance are fixed percentages of assets within a class or
type of asset. Fixed percentage rates are specified by type of asset. The fixed
percentage is multiplied by the tax basis of assets in service to determine the

21 P. SURESH BABU, ASST. Prof., DEPT OF EEE

 ENERGY AUDITING & DEMAND SIDE MANAGEMENT (9A02808)

capital allowance deduction. The tax law or regulations of the country specifies
these percentages. Capital allowance calculations may be based on the total set of
assets, on sets or pools by year (vintage pools) or pools by classes of assets.
Tax lives and methods
Some systems specify lives based on classes of property defined by the tax
authority. Canada Revenue Agency specifies numerous classes based on the typ e
of property and how it is used. Under the United States depreciation system, the
Internal Revenue Service publishes a detailed guide which includes a table of asset
lives and the applicable conventions. The table also incorporates sp ecified lives
for certain commonly used assets (e.g., office furniture, computers, automobiles)
which override the business use lives. U.S. tax depreciation is computed under the
double declining balance method switching to straight line or the straight line
method, at the option of the taxpayer. [7] IRS tables specify percentages to apply to
the basis of an asset for each year in which it is in service. Depreciation first
becomes deductible when an asset is placed in service.

22 P. SURESH BABU, ASST. Prof., DEPT OF EEE