Depreciation is an accounting concept that does not relate directly to current cash flows. How does...

Depreciation is an accounting concept that does not relate directly to current cash flows. How does it impact on a capital budgeting decision?

Expert Solution

Depreciation is reduction of book value on an annual basis. But there is no actual cash outflow. It is a non cash expense. Therefore, it must be added back to EBIT for calculating incremental operating cash flow. However, depreciation also provides tax benefit. This also should be taken into account while calculating operating cash flow. The concept can be best illustrated with an example.

Suppose revenue is $50,000, costs are $15,000, depreciation is $5,000 and tax rate is 30%

Operating cash flow = (Sales - costs - depreciation)(1 - tax) + depreciation

Operating cash flow = ($50,000 - $15,000 - $5,000)(1 - 0.3) + $5,000

Operating cash flow = $26,000

In the above example, tax benefit is taken into account and depreciation is added back to obtain operating cash flow. If depreciation was not added back, we might have to reject the project due to a lower cash flow. Therefore, depreciation plays an important role in capital budgeting decisions.

jeff jeffy answered 5 months ago

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