Question

Explain the impact of depreciation on cash flow of a capital project

Answer 1

Capital Project is a project in which the cost of project is capitalized.

Some Examples are Infrastructure projects such as subways, refineries, power plant, and building.

Capital intensive projects usually spends more in fixed assets such as buildings, equipment’s or vehicles , But these capital expenditure does not immediately appears as expenses on Profit and loss statement in this case the expense appears over time in terms of depreciation

The very common method of depreciation method used is straight line method which gives us consistent depreciation expense every year

Example

You are planning for Capital Project that requires $ 70000 in one go and you are expecting it will at least last for 15 odd years, and at the end it will have terminal value of $ 5000

Thus the total Amount depreciated would be $ 65000 ($ 70000 - $ 5000) so using straight line method we would distribute the depreciation expense equally by $ 65000/15= $4333

Impact on cash flow

Cash flow shows the real money coming or going out of the business

So initially depreciation method is not going the change the fact that at the beginning company has done a negative cash flow that is out flow of $70000 it will not immediately affect profit as it will not be shown in P&L statement , Although you are reporting depreciation of $ 4333 every year but it does not have direct impact on your cash flow as it is a noncash expense

However it does have indirect impact because it changes company’s tax liability, which in terms reduces out flow from income tax.

That means you’ll pay less taxes due to depreciation expense that has been mentioned in the P&L statement