Question

Why do we use incremental cash flows in a replacement decision?

How would international investing affect the calculation of the cash flows?

If the IRS disallowed depreciation how would that affect a firms capital budgeting decisions?

Answer 1

(1). Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced.

Calculating periodic cash flows of existing asset is straight forward. Since the existing asset is already purchased, the initial investment outlay is zero and the periodic net cash flows are calculated based on the following formula:

Net cash flows = (revenue – operating expenses – depreciation) * (1 – tax rate) + depreciation

If the asset is replaced, it involves investment is the new asset and sale or disposal of the existing asset. Disposal of exiting asset has some income tax implications which need to be reflected in the calculation of initial investment as follows:

Initial investment after replacement = cost of new asset - sale proceeds of old asset +/- tax on disposal

Tax on disposed asset = (sale proceeds of old assets – book value of old asset) * tax rate

(2). FDI(foreign direct investment ) or international investment is part of overall globalization of markets. It may be in the forms of project finance, subsidiary investment, new venture, joint venture etc. Capital budgeting for FDI requires

• forecasting the impact of future market conditions,

• exchange rate estimates

• taxes on the profitability of a project

• discount rate has to appropriately account for risk.

• Country risk which include political risk, government default risk, unexpected inflation etc. besides the market risk of exchange rate fluctuation, interest rate volatility etc.

(3). Although depreciation expense is not a cash outflow, it does reduce taxable income and thereby reduces taxes that is

Depreciation tax savings cash inflow = Depreciation expense × Tax rate

• Since depreciation is listed as an expense, it reduces the amount of taxable income. If IRS doesn't allow Depreciation  entity cannot take tax saving deduction of depreciation resulting in Increase in cash Outlay , but if depreciation is allowed to be a tax-deductible expense, it will reduce the tax payment for a company.

  With the company paying less in taxes, net income would be higher. And since net income is used as the starting point for calculating cash flow, net income would be higher as a result of the tax benefit deduction of depreciation. Although depreciation does not involve an outlay of cash, it could indirectly boost net income if depreciation expenses are a tax deduction, reducing the cash outlay for a company's taxes.

• depreciation is an accounting measure and is added back into revenue or net sales when calculating a company's cash flow. As a result, depreciation does not affect cash flow. However, depreciation can have an indirect impact on cash flow