CDFA Spotlight: IDBs vs. Accelerated Depreciation By Stan Provus

Preface

This article provides an analysis of the impact of straight-line depreciation vs. accelerated depreciation on the cost-effectiveness of qualified Small Issue bonds for manufacturers (as used here “IDBs”). The Internal Revenue Code (IRC) requires the use of straight-line depreciation to depreciate assets financed with tax-exempt, qualified small issue bonds. Some argue that this restriction can make conventional financing more cost-effective than IDB financing, because accelerated or double-declining depreciation can be used with conventional financing. Our analysis indicates this is not the case, although the accelerated depreciation prohibition certainly reduces the cost-effectiveness of IDBs, particularly on shorter-term transactions.

Case Study Assumptions

Ø Tax Exempt Case Study. Using 4.5% tax exempt bond financing, a manufacturer purchases $1 million in buildings and $1 million in equipment, under the straight line method, assuming a 40% tax bracket, a five year equipment life, a forty year useful life for the buildings, and zero scrap value. Five and twenty year financing for the equipment and buildings, respectively.

Ø Conventional Case Study. Using 6.5% conventional financing, a manufacturer purchases $1 million in buildings and $1 million in equipment, under the “double declining" method, otherwise known as the 200 percent declining method, assuming a 40% tax bracket, a five year equipment life, a forty year useful life for the buildings, and zero scrap value. Five and twenty year financing for the equipment and buildings, respectively.

Other Assumptions

Ø A 2% “all-in” interest rate spread between conventional and tax-exempt financing—4.5% vs. 6.5%. From 1990-2005, the average spread between tax-exempt variable rate demand obligations or notes and prime was 4.14%. Since 1985, the average spread between 1 month LIBOR (another common conventional index) and the Bond Market Association (BMA) variable rate demand obligation index was 1.7%--however, many LIBOR borrowers must pay LIBOR plus 100-200 basis points. Thus, the 2% spread assumption is reasonably conservative.

Ø The borrower can fully utilize depreciation and interest expenses at the 40% tax rate. Many borrowers may not be able to do this, since it can take time to generate significant profits from new equipment and buildings.

Ø Excel spreadsheets were prepared to support the findings reached in this article.

Ø Depreciation and interest were first calculated on an actual basis and then a 4.5% present value factor was used to determine the net present value of the cash flows—annual depreciation and interest charges.

Ø Present value cash savings from the IDB financing (difference between the tax-exempt and conventional present value amounts) were further reduced by the tax effect of paying more interest and getting higher depreciation on the conventional financing. These reductions of IDB savings were significant and largely attributable to the higher interest paid on conventional financing.

Ø Straight-line and double declining depreciation schedules were obtained from: http://www.fixedassetinfo.com/calculator.asp

Findings

Ø IDB financing would save the borrower $101,529 in present value dollars.

Ø The IDB equipment financing would save 1.94% of the $1 million borrowed.

Ø The IDB real estate (buildings) would save 8.2% of the $1 million borrowed.

Ø Tax-Exempt IDB financing for the equipment relative to conventional financing would yield present value cash savings of $50,160. The present value (PV) of paying more interest and higher depreciation for the conventional financing reduced cash savings by $30,807, yielding a $19,353 total IDB PV financing savings on the equipment. As shown below, this savings is far less than the 20 year IDB financing on the buildings, largely because the advantages of accelerated depreciation has more benefit on shorter term financings than longer term because there is far less interest rate savings to offset its advantages.

Ø Tax-Exempt IDB financing for the buildings (real property) relative to conventional financing would yield present value cash savings of $193,338. The present value of paying more interest and higher depreciation for the conventional financing reduced cash savings by $111,162, yielding a $101,529 total IDB PV financing savings on the buildings.

Calculations

Equipment

Tax-Exempt IDB
Straight-line (SL) depreciation-Tax Benefit (40% bracket)
Actual lifetime depreciation benefit	$400,000 ($1 million x .40)
PV assuming 4.5% discount rate	$343,636
Actual Lifetime Interest at 4.5%	$118,581
PV assuming 4.5% discount	$107,577.
PV Tax Benefit of Depreciation	$343,636
PV Tax benefit of Interest Deduction	$43,030 ($107,577 x .40)
Total Tax Benefit	$386,666
Conventional Financing
Double Declining Depreciation w/40% tax bracket
Actual lifetime depreciation benefit	$400,000 ($1 million x .40)
PV assuming 4.5% discount rate	$354, 378.21
Actual Lifetime Interest at 6.5%	$173,970
PV assuming 4.5% discount	$157,737
PV Tax Benefit of Depreciation	$354,378
PV Tax benefit of Interest Deduction	$63,095 ( $157,737 x .40)
Total Tax Benefit	$ 417,473
Conventional PV Interest	$157,737
IDB PV Interest	($107,577)
Cash IDB PV interest savings	$50,160
Tax effect of higher deductions for depreciation and interest on conventional financing	($30,807)
Total PV IDB Savings	$19,353

Tax-Exempt IDB
Straight-line (SL) depreciation-Tax Benefit (40% bracket)
Actual lifetime depreciation benefit	$400,000 ($1 million x .40)
PV assuming 4.5% discount rate	$183,686
Actual lifetime Interest at 4.5%	$518,359
PV assuming 4.5% discount	$378,258
PV Tax Benefit of Depreciation	$183,686
PV Tax benefit of Interest Deduction	$151,303 ($378,258 x .40)
Total Tax Benefit	$334,989
Conventional Financing
Double Declining Depreciation w/40% tax bracket
Actual lifetime depreciation benefit	$400,000 ($1 million x .40)
PV assuming 4.5% discount rate	$217,513
Actual lifetime Interest at 6.5%	$789,377
PV assuming 4.5% discount	$571,596
PV Tax Benefit of Depreciation	$217,513
PV Tax benefit of Interest Deduction	$228,638 ($571,596 x .40)
Total Tax Benefit	$ 446,151
Conventional PV Interest	$571,596
IDB PV Interest	($378,258)
Cash IDB PV interest savings	$193,338
Tax effect of higher deductions for depreciation and interest on conventional financing	($111,162): (334,989-446,151)
Total PV IDB Savings	$82,176
Total Equipment and Buildings IDB PV Savings	$101,529

Amortization Schedule – 5 years Spreadsheet

Straight-line vs. Double Declining Spreadsheet

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.