Question

Explain all the reasons why it is necessary to calculate depreciation on an old and/or new asset when estimating a project's net cash flow?

Answer 1

Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset. Depreciation Accounting deals with the allocation of costs of fixed assets over their useful lives.

Depreciation is considered a non-cash expense, since it is simply an ongoing charge to the carrying amount of a fixed asset, designed to gradually reduce the recorded cost of the asset over its useful life. When creating a budget for cash flows, depreciation is typically listed as a reduction from expenses, thereby implying that it has no impact on cash flows. Nonetheless, depreciation does have an indirect effect on cash flow.

When a company prepares its income tax return, depreciation is listed as an expense, and so reduces the amount of taxable income reported to the government (the situation varies by country). If depreciation is an allowable expense for the purposes of calculating taxable income, then its presence reduces the amount of tax that a company must pay. Thus, depreciation affects cash flow by reducing the amount of cash a business must pay in income taxes.