Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

Australian companies can use either the prime cost method or the diminishing value method to depreciate

assets. Under the prime cost method, companies depreciate assets by an equal amount each year (the annual

depreciation charge will be equal to the purchase price of the asset divided by  the effective life). This is

effectively a straight-line depreciation. Under the diminishing value method, the annual depreciation charge

will be a fixed percentage of the remaining value of the asset, making this a reducing balance method. The

percentage used in calculating the diminishing value is 200% of the inverse of the effective life of the asset.

The diminishing value method allows companies to take larger depreciation deductions in the early years of an

asset’s life. The cash flow effect of this system is to accelerate the tax benefits associated with depreciation.^2

Table 10.2 provides an example of how a company may depreciate its assets using each method.

TABLE 10.2 DEPRECIATING AN ASSET USING PRIME COST AND DIMINISHING VALUE

This table shows how an office machine purchased for $14,000 would be depreciated using both the prime cost and the diminishing

value methods. Based on the Australian Tax Commissioner’s ruling on effective lives, this would have an effective life of five years.

Thus the prime cost rate would be 20%, and the diminishing value rate would be twice that, at 40%. As the table demonstrates,

the diminishing value method will provide higher depreciation charges towards the start of the asset’s life than will the prime cost

method. This will result in an increased tax deduction towards the start of the asset’s life. However, even after the five years are

over, the book value will not be diminished to zero, using the diminishing value method.

Prime cost depreciation

(depreciated at 20%)

Diminishing value depreciation

(depreciated at 40%)

Year Depreciation charge Depreciated book value of

the asset

Depreciation charge Depreciated book value of

the asset

0 $ – $14,000 $ – $14,000

1 $2,800 $11,200 $5,600 $ 8,400

2 $2,800 $ 8,400 $3,360 $ 5,040

3 $2,800 $ 5,600 $2,016 $ 3,024

4 $2,800 $ 2,800 $1,210 $ 1,814

5 $2,800 $ – $ 726 $ 1,089

Curtains and drapes 6

Fire extinguishers 15

Hot water installations for commercial office buildings

(excluding commercial boilers and piping)

15

Lawn mower:

motor

6

2

3

self-propelled 5

Library (professional) 10

Motor vehicles:

cars generally 8

hire and travellers’ cars 5

Taxis 4

Motorcycles and scooters

6

2

3

Office machines and equipment:

photocopying machines 5

Source: © Australian Taxation Office for the Commonwealth of Australia 2014. ‘Guide to Depreciating Assets 2014’, Australian Taxation Office.

TABLE 10.1 EXAMPLES OF EFFECTIVE LIVES OF ASSETS FROM JULY 2013 (Continued)

prime cost method
A method of depreciating
assets, accepted by the
Australian Taxation Office,
whereby assets are depreciated
by a set value every year. It
is analogous to the reducing
straight-line depreciation used
in accounting, and effectively
means that the asset will be
reduced by the same amount
each year until it has zero value.
The prime cost rate is calculated
by obtaining the inverse of the
effective asset life. Thus prime
cost rate = (1/effective asset
life) × 100%

diminishing value method
A method of depreciating
assets, accepted by
the Australian Taxation
Office, whereby assets
are depreciated by a set
percentage of their remaining
value every year. It is
analogous to the reducing
balance method used in
accounting, and effectively
means that, in theory, an asset
will never have zero value. The
percentage used to calculate
the diminishing value is set at
twice the prime cost rate. Thus
diminishing value rate = (1/
effective asset life) × 200% 2 That is, the tax benefits accrue faster than would be the case under prime cost (straight-line) depreciation.