Question

Boy, the accountants have a whole bunch of ways to calculate depreciation for the books, and they suggest that as long as you are consistent in your treatment, and there is a valid reason to use the method that you do, it is OK.

Does it matter for Capital Budgeting which depreciation method you use? After all, it is non-cash any way, isn't it?

Answer 1

Depreciation does not directly impact the amount of cash flow generated by a business, but it is tax-deductible, and so will reduce the cash outflows related to income taxes. Depreciation is considered a non-cash expense, since it is simply an ongoing charge to the carrying amount of a fixed asset, designed to 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.

This tax effect can be increased if the government allows a business to use accelerated depreciation methods to increase the amount of depreciation claimed as a taxable expense, which thereby reduces the amount of cash outflow for tax payments even further in the short term (though this leaves less depreciation to claim in later periods, which reduces the favorable tax effect in those periods).

There are different methods in deprecation calculation. Primarily methods used are Straight-Line Depreciation, Declining Balance Depreciation, Sum-of-the-Years' Digits Depreciation, Units of Production Depreciation.

When analyzing capital projects, companies are incentivized to apply accelerated depreciation methods because accelerating depreciation generates higher after-tax cash flows in the project’s early years. As a result of higher early year after-tax cash flows, accelerated depreciation methods typically create higher net present values when compared to the straight-line depreciation method.