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The Color of Money – Part II

February 28, 2012

In yesterday’s post, The Color of Money – Part I, I gave the big picture answer to Cap’s query. Today we will dive into the first of three sets of details that impact the answer, namely depreciation. In subsequent posts we will examine discounting and other assumptions. I had to pull out my green eyeshades to properly address depreciation. In the foreground of each of the graphs in yesterday’s post, a table of assumptions was provided. In the illustration below I zoom in on the second table to shed light upon the details.

Depreciation is the allocation of capital cost over an accounting life of an asset. The accounting life and the actual life are not the same thing. Accounting life generally considers the actual life together with regulatory requirements and generally accepted accounting principles (GAAP). The accounting life for new cable is usually 40 years, so 40-years is the model assumption for “Replacement asset life” in cell B8.

There are a variety of ways in which the original capital cost of, say, a new cable might be spread over its accounting life of 40 years. The simplest method is called straight-line depreciation and it allocates an equal amount of depreciation expense for each of the 40 years of anticipated life. In our example, the replacement cost of $33.00 per foot in cell B7 would be spread over 40 years, and hence the annual straight-line depreciation would be 82.5¢ (i.e. $33 ÷ 40 yrs). There are other depreciation methods that accelerate expenses into the earlier years of the asset life. In my example, the double declining balance (DDB) method is used for tax purposes in cell B9. Wikipedia does a nice job of defining the concepts of depreciation, so the interested reader should visit …

http://en.wikipedia.org/wiki/Depreciation.

Now for a not-so-secret secret – investor owned utilities keep at least two sets of books! One set of books is kept for the taxing authorities and the second set of books is kept for regulatory authorities. Often a third set of books is kept for internal purposes, but that has no impact on our analysis, because all we care about is actual cash flow.

the color of moneyIn my next post in this series we will dive into discounting, but for now let’s agree that accelerated savings are good—a dollar saved today is worth more than a dollar saved tomorrow. That’s why for the tax books, the accountants use the most aggressive depreciation allowed by the tax authorities. For our example, I used DDB that switches to straight-line when straight-line becomes more favorable. The “2” in cell B9 represents the “Double” in “Double Declining Balance.” The switch to straight line is controlled by a “True/False” switch in cell J9, which is not shown for brevity. If one has a depreciation expense of $100 and an “Incremental Income Tax Rate” of 32%, one would enjoy a $32 tax benefit. This is so because the $100 expense offsets $100 of revenue on which no taxes need be paid.

Now to the second set of books. As long as the “Rate of Return on Capital” in cell B5 is greater than the “Discount Factor” in cell B3, it is to the circuit owner’s advantage to use the slowest depreciation method allowed by the regulators. In the long run the rate of return must be greater than the discount factor or investments by the circuit owner would make no sense. The FERC (Federal Energy Regulatory Commission) promulgates a Uniform System of Accounts (USoA) to regulate how capital assets are depreciated. For the example provided in this model, regulatory depreciation is straight line, indicated by a “1” in cell B10.

What if your firm is not an investor owned utility? What if your firm does not pay any income taxes? At first glance it appears that publicly owned utilities should set both their incremental income tax rate and rate of return on capital to zero. That would ignore the stakeholders of public utilities have the same expectation of economic return as their investor owned neighbors. If the publicly owned entity did not provide a return in the form of lower electrical rates or direct payments to a governmental unit, there would be a strong case to privatize the utility. I would argue that the same values used by neighboring investor-owned utilities should be utilized for this analysis.