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Amity Business School

Amity Business School


MBA Class of 2013, Semester II Financial Management Module IV

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Treatment of Depreciation

For taxation purposes, depreciation is charged (on the basis of written down value method) on a block of assets and not on an individual asset. A block of assets is a group of assets (say, of plant and machinery) in respect of which the same rate of depreciation is prescribed by the Income-Tax Act.

Block of assets as per the Income Tax Act


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Buildings 3 Blocks 5% Depreciation 10% Depreciation 100% Depreciation Furniture 1 Block 15% Depreciation Plant & Machinery 7 Blocks 20% Depreciation 25% Depreciation 40% Depreciation 50% Depreciation 60% Depreciation 80% Depreciation 100% Depreciation

For the 4 Classes of Assets ,


we have

12 Block of Assets

Intangible assets 1 Block 25% Depreciation

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Capital Gain arises in the following situations


(i) When the sale proceeds exceeds the WDV ( Written Down Value) of the whole block (ii) When the entire block is sold out.

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Asset
Plant P

Rate of Depreciation
25%

WDV as on 1-4-2008
80,000

Plant Q
Plant R Plant S

25%
25% 25%

60,000
40,000 20,000 2,00,000

P,Q,R,S form a single Block of Assets having 25% Depreciation.

Written Down Value of the Block of assets

BHEL owns the following assets as on 31.3.09


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Asset Rate of Depreciation WDV as on 1-4-2008

Plant P
Plant Q Plant R Plant S

25%
25% 25% 25%

80,000
60,000 40,000 20,000 2,00,000

(a) Plant P is sold on 15-3-2009 for Rs. 2,20,000. Compute the Capital Gain/Loss

(b) Plant P is sold on 15-3-2009 for Rs. 1,80,000. Compute the Capital Gain/Loss
(c) Plant P,Q,R,S are together sold for Rs. 1,90,000. Compute the Capital Gain/Loss (d) Plant P,Q,R,S are together sold for Rs. 2,50,000. Compute the Capital Gain/Loss

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Case (a)

Sale Proceeds Less : WDV of the Block Capital Gain

2,20,000 2,00,000 20,000

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Case (b)

There will be no Capital Gain, in this case, because the sale consideration is less than the value of the block.

WDV , on which depreciation is allowable is Rs.20,000 (2,00,000 1,80,000)

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Case (c)

Sale Proceeds Less : WDV of the Block Capital Loss

1,90,000 2,00,000 10,000

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Case (d)

Sale Proceeds Less : WDV of the Block Capital Gain

2,50,000 2,00,000 50,000

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X owns two machineries eligible for depreciation at the rate of 25%. The WDV of these machines as on 1.4.2008 was Rs. 25,000 and Rs. 40,000 respectively. No other asset was acquired in this block during the year. Both these machines were sold during the year for Rs. 60,000. Is there any Capital Gain/ Loss ? If yes, then what amount ?

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Depreciation is charged on the year-end balance of the block which is equal to Opening balance of the Block of assets

+ purchases of assets made during the year (in the block considered) - sale proceeds of the assets during the year.

To Summarize

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In case the entire block of assets is sold during the year (the block ceases to exist at year-end), no depreciation is charged at the yearend. If the sale proceeds of the block sold is higher than the opening balance, the difference represents short-term capital gain which is subject to tax. Where the sale proceeds are less than the opening balance, the firm is entitled to tax shield on short-term capital loss.
In case an asset falling in a block of assets is sold out ( for an amount that is less than the WDV of the whole Block), there is no Capital Gain. The sale proceeds of the asset are reduced from the WDV (Written down Value) of the block.

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Treatment of Working Capital in Project Evaluation

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Almost every Investment proposal requires an additional investment in Working Capital (in some form or the other). The proposal, if accepted would require increase in minimum Cash Balance , higher inventory levels or more receivables. Any additional investment in working capital cannot be used elsewhere and is similar to an investment made in building, plant. Machinery etc. It has to be viewed as a cash outflow, when it is made. At the end of the proposal , this additional working capital being invested now will be released . Thus, any decrease in working capital can be treated as a release of working capital or cash inflow.

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Hence, Cash needs for working capital should be treated as a cash outflow at the time of commencement of a project and should be treated as inflow when that cash is released at the time of closure or termination of projects.

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Requirements of Good Method of Project Evaluation


It should be based on cash flows rather than on profits or expenditures.
Cash flows to be recovered over the entire expected life of the asset rather than few years only. It should consider the time value of money. It should indicate relative profitability between different alternatives, so that a ranking can be made between different proposals. It should indicate the degree of risk and the chances of getting profit or loss in a given situation.

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