Question

How is the MACRS depreciation method under IRS rules different from the straight-line depreciation allowed under GAAP rules? What is the implication on incremental after-tax free cash flows from firms’ investments?

Answer 1

Straight Line Method is a depreciation method that gives you the same depreciation year after year over the assets useful life. The depreciation is calculated by dividing the assets actual cost by it's useful life. On a graph the asset value over time would appear as a line sloping downward.

On the other hand MACRS Depreciation method gives bigger tax deduction in the earlier years when the asset is new and lower tax deduction towards the end life of the asset.

Because most of the companies ues MACRS depreciation the IRS applies it by default but you can also use straight line method.

However straight line method is the only method available for intangible asset s which can not use MACRS or Sec 179.

If you opt to use straight line method you should use it for all classes of assets and you can not switch to MACRS method in between.

Moreover the fundamental difference between IRS and GAAP method of depreciation is that MACRS is recommended by IRS where's as GAAP method is recommended by SEC for proper auditing taxation purposes because it provides a standard measurement.For auditing purposes straight line method is preferred under GAAP rules.

Explanation on Part 2 of question

Incremental after tax casflows is the additional operating cashflow is the cashflow that an organization experiences on acceptance of a new project.

Incremental after tax casflows is the potential increase or decrease in the companies cash flow related to the acceptance of a new project or investment in a new asset.Postive increment is a good sign for the company.

In nutshell incremental casflows is the net cash flow from all inflows and outflows over a time and between various choices.