Question

Which of the following statements is FALSE? Depreciation is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. Sometimes the firm explicitly forecasts free cash flow over a shorter horizon than the full horizon of the project or investment. Earnings include the cost of capital investments, but do not include non-cash charges, such as depreciation. Firms often report different depreciation expenses for accounting and for tax purposes.

Answer 1

(1) Depreciation is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life.

TRUE

Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up.

Sometimes the firm explicitly forecasts free cash flow over a shorter horizon than the full horizon of the project or investment.

TRUE

(2) Sometimes the firm explicitly forecasts free cash flow over a shorter horizon than the full horizon of the project or investment. This is necessarily true for investments with an indefinite life, such as an expansion of the firm.

(3) Earnings include the cost of capital investments, but do not include non-cash charges, such as depreciation.

FALSE

Earnings include non-cash charges, such as depreciation, but do not include the cost of capital investment. To determine the project’s free cash flow from its incremental earnings, we must adjust for these differences. We need to add back depreciation to the incremental earnings to recognise the fact that we still have the cash flow associated with it.

(4) Firms often report different depreciation expenses for accounting and for tax purposes.

TRUE