Now I'm going to talk to you about another strategy that is commonly used in the rental business for dealing with depreciation. It's talking about having a residual value. And so I have overlaid the prior slide with a different strategy that says we're going to take the machine down in a five year straight line approach, but we're not going to take it all the way down to zero value because even for scrap value purposes, we know we could sell the machine for at least 10%. So what would be the advantage of taking it all the way down to zero on the books and then just having that equity sitting on the books? So a common approach to dealing with depreciation is this idea of I will do a straight line with a residual of 10%. So what that means is instead of taking the entire value of the machine down over five years, which is 20% per year, we're going to take the value of the machine down 90% in five years. So if you divide 90 by five, you get 18. So therefore the impact of depreciation on this machine is 18% per year, not 20. So what happens to that extra 2%? Well see that's a 2% expense that has been being put against the rental fleet. Well if we don't have that expense, that means we can have 2% more per year show up on the profit in the rental department. So what you have to decide is, is this a conservative approach or not to take it all the way down to zero or could we be just fine with taking it down to 90%? Because 2% more is going to show up in profits in the rental department. So again this gets down to where do you want to show the profitability? Do you want to show it during the operating period of the asset or do you really want to just show it when you sell the asset at the very end? Now I also want to point out to you if you look in the chart, the dotted line, the dashed line is this new approach. And so you see the margins stay tighter from the very beginning into the third year and then they start to stretch. So this idea of minimizing, if you will, the depreciation is a strategy that's using, to be used if you're planning on keeping that equipment into your rental fleet probably 3, 4, or 5 years. If you were going to try to sell that machine in a 24 month or 30 month period, I don't believe that this would be much of a strategy for you. So what you have seen so far is 5 year straight line depreciation, taking it to zero, and now you've just looked at 5 year depreciation with a 10% residual. So another approach that is again very common by some is the idea of a 7 year straight line depreciation. So one of the things you have to look at here is check out year 2, how tight those lines are. So if you were planning on selling machinery in the second to third year, you would not pick this type of depreciation for your rental fleet because you're going to show virtually no profit at the time you sell those machines. But take a look at what happens to the, instead of 20% per year being an expense against the rental fleet, you'd only be expensing 14.23% per year. That's 5.5% that shows up in the profitability of the rental fleet. So in my opinion, the reason that you would use something like this is if you have some real long term confidence in equipment values into the future. As you can see, by the difference between the blue line and the red line, it would be possible for you to potentially get upside down, meaning that you had not depreciated the asset fast enough on your books, and therefore at the time of sale, you actually have it on the books at a higher price than what it's actually worth on the street. The last strategy I'm going to talk to you about for depreciation is one that is very common amongst equipment dealers in the U.S., and it's this idea of a revenue-based depreciation instead of a time-based depreciation. The other models that we have looked at so far do not take into account whether you're actually renting the machine very much or not, because it is going on a month-by-month depreciation, even if the machine is just sitting in the yard. But a lot of dealers have used this strategy in their rent-to-sell fleet, and in some cases it has leaked over, if you will, to the rent-to-rent. The concept here is the idea that if the machine is sitting still and it's not working, we don't have any depreciation cost. But if it does go out on rent, whatever rental income we take in on that machine, we're going to book 80% of that revenue as a depreciation cost. What tends to happen here is that it starts to put a lot of depreciation booking against the machine, because what we're really doing is driving the value of that machine down on the books. In other words, we're expensing 80% of this rent revenue. And so, as you can see, the gap between the market value and the book value, it gets bigger really fast. Well, the idea here is that you're going to show this margin when you sell the machine, and you can also get to a more attractive sales price faster. So typically, the difference would be the net book value would come down about another 5% faster per year, whereas we said straight line depreciation over five years brought it down 20% per year. In this illustration, you'd be bringing it down roughly about 25% per year. Well, again, this has to do with where do you want to show your profit margin? Do you want to show it during the time that it's in the rental fleet and you're showing profitability, or do you want to show heavy expenses into the rental department and then show the profit when you sell this used machine? I will tell you that the IRS has some real hard and fast rules about depreciation. And so, you as a dealer can't just decide, I'm going to do one or the other. There are real regulations about assets and how fast you can write them down. As you might imagine, the IRS does not want you to write things down too quickly because what you're really doing is you're overstating your expenses, which means that you have less taxable income. So what they really want is they want a reasonable amount of depreciation expense, and then they'd still like to get some tax money on your profits. So make sure that somebody at your company has been looking into the regulations associated with writing depreciation on rental fleets so that you're within the guidelines of the law. What you don't want is an IRS tax audit that goes back for years and discovers, gee, we've been using this method for depreciation, and actually it was outside the limits of the law. So I'm not a fan of the revenue-based depreciation for two reasons. One, that it does not recognize the profitability in the rental department. And then secondly, if that machine just sits there and you've got this machine that sits the wrong size, it's got the wrong configuration, and nobody wants it, it's just going to sit out there by the fence, and there is no depreciation running against this machine because it's just sitting there. And so the price on this machine is not going to get better into the future. Whereas if you have a time-based depreciation, that means you as a rental manager, it's got a cost against you every month for that machine sitting there, and you're going to have to get a little creative in how to get it out of your yard, get it out on rent, making some kind of money, so that eventually you can get it at a price point that you can sell the machine. So there is a real behavior difference in terms of how managers operate. If you have a time-based depreciation, what that means is the beginning of every month, you know that you have this fixed expense that's going to go against your fleet, and you've got to earn revenue to outrun that. But if you had a fleet of equipment and it was all revenue-based depreciation, then basically you're treating depreciation as if it's a variable expense, and I only have it when I'm renting the machine, and that's really not reality.

depreciation strategies

residual value

seven-year straight line depreciation

revenue-based depreciation

time-based depreciation