Capital depreciation refers to the decline in value of a capital asset.
To give a simplified example, if a machine is bought for $10,000 but only has a useful lifespan of five years, then every year, the value of this machine will decline by $2,000.
After three years, the machine is worth $4,000. There has been capital depreciation of $6,000.
How depreciation can occur
- Machine wears out. It requires either costly repairs or may need to be replaced completely.
- Obsolescence. If a music firm invested in a factory to produce CD players, then the rise of digital music would cause a rapid obsolescence of this ‘old technology.
- Resale value falls. If you buy a car, then after one day, its resale value falls significantly because it is no longer a new car, but fits into the ‘second-hand category’ – even though it is the same car, its value has fallen.
- Change in demand. Capital can also fall in value due to a decline in demand for the good it makes.
1. Value of goods and services from the capital asset If a new machine can produce 10,000 widgets at $2. Then its value is $20,000. If after five years, it’s useful life cycle is to produce only 2,000 more widgets, at $2. Then its value is now just $4,000. In this case, there is a capital depreciation of $16,000
- If the value of the good significantly rose, then, in theory, it could become worth more over time, and there would be negative depreciation
- In practice, it can be difficult to evaluate the working life of a model. Typically a machine may be expected to last five years, but if it breaks down, then its useful value falls immediately.
2. Fall in resale value. Another method of measuring depreciation is the resale value.
However, a firm may gain greater value from a machine than its resale value. For example, a highly specialised machine may have no resale market at all. (e.g. tunnel for digging Channel Tunnel) but just because it has zero market value doesn’t alter the fact it can still be very useful to the company
Depreciation and the link between Gross and net investment
- Net investment = gross investment – depreciation
If a firm spent $150,000 on new computers. Then the gross investment is $150,000. However, if there was depreciation of $40,000 (e.g. writing off the fall in the value of obsolete old computers), then the net investment is $110,000.
Depreciation and national accounts
In national accounts of gross domestic product, depreciation is referred to as ‘consumption of physical capital’ It is the difference between gross investment and net investment.